Sunday, January 31, 2010

Mr. Bernanke and the Perplexing Populism of a Naubel Laureate

Now that Ben Bernanke has been confirmed by the Senate for a second four-year term as Fed Chairman, averting a potentially major financial market turmoil and the embarrassment of this country in the eyes of the world, it is high time to focus on two memorable quotes by two high-profile public figures during the heady week recently when opposition to Mr. Bernanke's confirmation seemed to be gathering steam.

It was hardly surprising to hear Senator Barbara Boxer (D-Calif) declare on January 22 that, despite her professed regard for the Fed Chairman, she would vote against Bernanke's confirmation because " is time for Main Street to have a champion at the Fed"- whatever Main Street's champion at the Fed exactly entails. Such a decision and rationale could have easily been brushed aside as standard populist rhetoric by a professional politician up for re-election this year and fighting for her political life.

But it was an entirely different, and somewhat disturbing, matter, to read the following in Paul Krugman's op-ed column in The New York Times, on January 26, where he was explaining why the most he could muster to offer to his former colleague at Princeton was a very tepid endorsement.

"And then there's unemployment. The economy may not have collapsed, but it's in terrible shape, with job-seekers outnumbering job openings six to one. Nor does Mr. Bernanke expect any quick improvement: last month, while predicting that unemployment will fall, he conceded that the rate of decline will be "slower than he would like". So what does he propose doing to create jobs?

Nothing. Mr. Bernanke has offered no hint that he feels the need to adopt policies that might bring unemployment down faster."

Now, this is serious double-take material.

What kind of policies should the Fed have adopted to "bring unemployment down faster"? Bring short-term rates down to zero and keep them there for 14 months now, while still promising to keep them at that level "for an extended period"? Already done. Set in place an unprecedented array of programs to inject an enormous amount of liquidity, providing the "raw material" that banks- once they are past their critical survival phase- will have available to extend more lending? Done, too.

The most disturbing part though is this: Doesn't Mr. Krugman realize that measures specifically designed to create jobs and bring the unemployment rate down are the exclusive domain of fiscal policy and that the Fed is not part of either the Executive or Legislative branches of the government that shape such policies ? Doesn't he realize that the Fed has no legal power, whatsoever, to mandate banks to increase lending against their will? Doesn't he realize that Mr. Bernanke's view that the rate of decline in the unemployment rate "would be slower than he would like" is not a reflection of indifference on his part toward the social impact of a 10% rate but simply a realistic assessment of the economic trajectory ahead and the Fed's own ironclad limitations in regards to affecting that outcome?

It does not take a Nobel Laureate in Economics to understand those simple facts and Mr. Krugman is certainly more than qualified to recognize them fully. Then, what one is to make of the promotion of such populist, and misleading, arguments against Bernanke on a high-profile forum like The New York Times?

As we have argued before, Bernanke carries a very major responsibility for the Fed's lax supervision of the banking system while the imbalances that led to the financial crisis were brewing, and he has repeatedly acknowledged that himself. But attacking him on the grounds that, as a central banker, with the record of the measures he has taken in the last 18 months or so, he is not doing enough to bring the unemployment rate down is dsiturbingly off-base.

Populism has its role in the public discourse in any democracy but it is always disheartening to see it popping up in the most unexpected of places.

Anthony Karydakis

Friday, January 29, 2010

Fourth Quarter GDP Consistent With a Moderate Recovery

The press headlines so far uniformly highlight that the 5.7% annualized growth rate for Q4 GDP is the highest in six years, which is factually true. But this morning's report is also a textbook-like case of the hard reality that, after all is said and done, GDP numbers are a "bean counting exercise". This means that GDP consists of a number of components, each one of which is subject to a high degree of noise from one period to the next, and, at times, those multiple sources of noise can present a distorted picture of what is actually going on.

Source: Bloomberg, Haver Analytics

The primary reason for the seemingly impressive growth rate last quarter was a dramatically slower pace of inventory liquidation, which added 3.4 percentage points to the overall GDP number, following a far more moderate contribution of 0.7 percentage points to the previous quarter's growth. Outside of inventories, real final sales (that is, overall GDP minus inventories) grew at a relatively subdued 2.2% rate.

Personal consumption rose 2% (following a 2.8% pace in Q3) contributing 1.4 percentage points to growth, while capital spending was up 2.9% (its first increase since Q2 2008), indicating an end to its free-fall in the prior five quarters. Net exports also contributed 1/2 a percent to growth, as imports declined sharply for the quarter.

Despite its impressive fourth quarter number, GDP contracted by 2.4% in 2009 compared to the previous year.

Now, inventory replenishment is a natural part of the turnaround in economic activity in any business cycle, as it represents the legitimate adjustment of businesses to the reality of stirrings in final demands following a recession. In that context, this is precisely what has been happening again in this cycle. In fact, this inventory adjustment process goes hand-in-hand with a pick up in underlying production, which is one of the key dynamics that set into motion an economic recovery. So, nothing wrong with that, per se. Still, it does deflect some attention from the reality that today's report shows most of the other GDP components recovering at an appreciably slower pace and remains consistent with the prospect of an overall moderate economic recovery ahead.

As the inventory rebuilding process is unlikely to be sustained in the coming quarters at the pace of the most recent period, GDP is likely to cool to 3.5% or so in the first half of the year, which would be roughly in line with the average growth in the second half of 2009 (3.9%). Although inventories should remain a net contributor to GDP in the quarters ahead, all eyes are now turning to personal consumption- and, to a lesser extent, capital spending- which will ultimately determine the kind of recovery that is in store for 2010.

Anthony Karydakis

Tuesday, January 26, 2010

Federal Funds Targeting: The End of an Era?

For over two decades now, the federal funds rate has been the key operating target of monetary policy in the U.S., as the Fed manipulated the availability of reserves in the banking system, via open-market operations, to achieve a particular level of that overnight interbank rate. Since December 2008, courtesy of the financial crisis, that rate has stood close to o% (or, as the Fed officially defines its target "within a range of 0% to 0.25%).

With a massive amount of quantitative easing put in place since the onset of the most acute phase of the crisis in September 2008, and with the Fed already actively exploring various tools that can be used in the balance of the year to drain over $1.2 trillion of extra liquidity still slashing around in the banking system, it is increasingly likely that fed funds targeting will be taking back seat in that process, if it has any seat at all.

The massive amount of liquidity that will need to be taken out of the system when the time comes is simply not on a scale that routine, even if aggressive, open-market operations (Reverse Repurchase Agreements) can handle. In fact, a distinct risk exists that attempting to adhere to procedures that have been used in the past to address "run-of-the-mill" needs to drain reserves from the banking system in order to handle such a monumental and complex task ahead would cause the Fed to lose control of the federal funds rate and deliver a major blow to its own credibility.

The need to be creative and invent new techniques to accomplish that task has been increasingly at the forefront of the Fed's preparedness efforts in the last few months. For example, just last month, the Fed Chairman proposed that the Fed offer term deposits to banks in addition to the current regime where the Fed pays interest on banks' excess reserves and reserve requirements. The idea remains the same: the Fed needs to implement effective ways to tie up progressively large amount of bank reserves and prevent them from being actively used for excessive loan creation that could fan inflation pressures when the economic recovery is on solid footing and the banking system has regained a greater sense of stability. Open-market operations were well suited in the past to handle tasks that were far more moderate in scope, when the only easing that the Fed might have put in place was of the qualitative kind. Things are very different now and the inadequacy of such tools is a fairly transparent issue.

It is precisely that problem that Richmond Fed President Jeffrey Lacker was addressing in some remarks he made earlier this month, when he raised the issue that the Fed is considering the adoption of the interest rate they now pay on bank reserves as the new benchmark rate, replacing the concept of a fed funds target used until now (see link below).

The premise here is that the Fed feels more confident that they can achieve better control over the amount of bank excess reserves and lending by manipulating the interest rate they pay banks on their reserves compared to any attempt to control the fed funds rate by targeting non-borrowed reserves via open-market operations (which had been essentially the mechanism until a year and a half ago).

The whole project of managing to drain that huge amount of extra liquidity with reasonable efficiency, accuracy, and in an orderly fashion, is likely to be a pretty complex one and will inevitably include some glitches along the way, given the complete lack of precedent. But it looks increasingly likely that we may be at the doorstep of a major overhaul in the Fed's longstanding operating procedures in the conduct of monetary policy.

If the Fed does indeed usher in a new period where they express monetary policy actions in terms of the level of interest rate paid on bank reserves rather than a federal funds target, a significant prospect exists that the latter may slowly fade into oblivion- another casualty of the financial crisis.

Anthony Karydakis

Friday, January 22, 2010

First Thoughts on Obama's Bank Reform Plan and the Comeback of a Legend

A more cynical view would be tempted to argue that the aggressive roll-out of the Administration's bank reform proposal yesterday was meant to quickly divert the public's attention from the Massachusetts election and ensuing unraveling of the health care reform plan. However true this may actually be, it should not detract from the merits of the proposed legislation that is widely, and accurately, reported to be the brainchild of Paul Volcker's efforts to address the fundamental causes that led to the recent financial crisis.

The three key elements of the proposed plan (1. limiting the size of banks, 2. prohibiting proprietary trading activities, and 3. prohibiting banks from investing in private equity firms or and hedge funds) are all appropriately far-reaching measures that go tot he heart of the reasons that caused the near- meltdown of the financial system in the last 18 months.

In the midst of the initial sense of gratification that one would feel to see that serious, drastic measures to address the root cause of what was wrong with the banking industry are now being put on the table, it is also imperative to view everything in a more realistic context and not uncork the proverbial champagne yet.

To begin with, as the messy process involving the proposed health care legislation demonstrated all too well recently, a proposal is not tantamount to actual legislation. In fact, despite the populist undertones that a plan to tightly regulate the financial industry inevitably contains, it is far from certain that there will be adequate bipartisan support in Congress to implement such aggressive measures that would take on the powerful industry's critical interests in a major way. In other words, the banking industry does not spend over $1 billion a year on lobbying expenses (an amount likely to skyrocket now) for nothing.

But the other major aspect of the proposed plan that may undercut its significance is the extent to which other countries would be willing to go along with comparable measures. Early response in Europe has been overall positive (that is, outside the stock markets), with warm endorsement of the plan by the major political parties in the U.K. (where it is also fully consistent with the views of the Bank of England Governor, Mervyn King) and generally supportive, but somewhat more guarded, comments coming from officials in continental Europe.

The degree of support that Obama's proposals will receive from other governments with developed financial market structures will be key to the ability of those measures to achieve their intended objective, even of they were to be converted into law fully in this country. In a global financial market universe, prohibiting banks from engaging in certain types of risk activities in some countries only would quickly lead to the emergence of other "locales" as the new financial centers for such activity that would escape those restrictions; the net result of that would be to re-inject systemic risk into the picture that could destabilize the global financial system again.

On an entirely separate aspect of yesterday's unveiling of the proposal, the unqualified deference that Obama showed toward Paul Volcker by referring to the plan as "the Volcker rule" and the sheer fact that the legendary former Fed Chairman was standing right next to the President of the United States brought some unmistakable echoes from the past. Thirty years after Volcker shook the world by launching his monumental, and utterly successful, fight to drive inflation out of the system, there he was again, at the twilight of his career and life, deservedly basking in the spotlight, offering again his trademark, courageous, no-nonsence, solutions to the biggest financial crisis since the Great Depression.

For someone like myself, who has always admired the man's extraordinary integrity, competence, and selfless committment to public service, it was gratifying to see Paul Volcker on center stage again. He still stands as tall as ever.

Anthony Karydakis

Wednesday, January 20, 2010

That Unflagging Demand for Treasuries

When the Fed's program to purchase a total of $300 billion of Treasury securities ended in October, concerns were raised that the removal of a major buyer supporting the market in the previous six months or so would tend to cause a setback for long-term yields. Those concerns were actually compounded by growing signs of an economic recovery taking hold- a dynamic that would have also been expected to push yields higher.

In fact, the Treasury market did come under pressure in the period from mid- November to late December, with long-term yields rising by more than 50 basis points. But the back-up in yields was most certainly of the moderate kind (not of the-end-of-the-world-as-we-knew-it kind), indicating that there was a potent underlying force that was offsetting the adverse dynamic of an economic recovery, large Treasury issuance, and the end of the Fed's program of Treasury purchases. Since then, yields have actually come off by about 20-25 basis points, with the 10-year note trading at around 3 5/8% again.

So, someone out there is clearly buying Treasuries.

The TIC (Treasury International Capital System) data for November 2009, released earlier this week, provide very useful insight regarding that question, as they showed a record $118.0 billion of net purchases of long-term Treasuries by foreigners during that month. This overshadows the previous record of slightly over $100 billion reported for June of last year.

Net Foreign Purchases of Long-Term Treasuries

Source: Action Economics

Contrary to the often popular perception that buying by foreign central banks is the primary factor supporting the U.S. Treasury market, such purchases represented actually a relatively small share of the overall amount in November. Foreign official institutions accounted for approximately $31 billion of those purchases, with the remaining $87 billion coming from private foreign investors, which demonstrates a broad-based interest in the Treasury market by foreigners.

The seemingly ferocious demand for long-term Treasuries is also intriguing for an additional reason. Despite the massive influx of funds into emerging markets in the second half of 2009, this does not appear to have come at the expense of the demand for Treasuries by foreign investors. The explanation here is presumably that the reduction in the perception of global market risk in the second half of 2009 has triggered such an enormous exodus of funds previously parked in cash instruments that has allowed both U.S. Treasuries and emerging markets to become beneficiaries of such money being put to work again.

The TIC data are indeed very volatile on a month-to-month basis and are typically revised- often, appreciably. In that context, it would not be surprising to see a strong payback in December for the impresive strength in November's numbers regarding net purchases of Treasuries. But the key point remains undiluted: foreigners maintain a strong appetite for Treasury securities and do not seem prepared to shun that market despite the relative restoration of calm in global financial market conditions.

In other words, the Treasury market is not simply a safe haven.

Anthony Karydakis

(In a future posting, we will look in to the role of China in the overall purchases of Treasuries by foreigners).

Sunday, January 3, 2010

Do Budget Deficits Drive Bond Yields?

(Due to a long-planned vacation out of the country, there will be no articles posted during that period, starting Monday, January 4th. New posts will resume after January 19h).


The notion that large budget deficits tend to lead to higher yields has generally been accepted over the years without much questioning among market participants. The basic idea is a fairly straightforward one: the large supply of securities associated with those deficits can cause an over saturation in the credit markets, creating a mismatch between supply and demand and, therefore, leading to lower prices (i.e higher yields).

The academic literature in the field of economics reaches essentially the same conclusion, by highlighting the so-called "crowding out" dynamic- which means that the intense competition for funds between the government and private sector in a period of large government issuance will squeeze out private borrowers while causing rates to rise.

The prospect of massive Treasury supply ahead has, in fact, been invariably mentioned as one of the main reasons for which long-term yields have backed up moderately in the last five weeks and are viewed as likely to drift higher in 2010 in good part due to that factor. It is, however, curious that, despite the very mixed, at best, evidence that Treasury supply has any lasting effect on Treasury yields, that notion continues to hold sway among fixed income market participants.

A classic, and fairly dramatic, example where that purported relationship was actually turned on its head in this country was in the '80s. Between 1981 and 1986, the budget deficit tripled in size (to a new record by the then historical standards), while the benchmark 30-year Treasury bond yield collapsed from approximately 15% to 7.5%. The main driving force of yields at the time was the aggressive easing by the Fed, reversing the spectacular tightening that had been put in place at the beginning of the decade to fight runaway inflation. With the Fed easing at a breathtaking pace and inflation falling rapidly, bond yields did not seem to care about the mushrooming budget deficit.

In the late '90s again, when the budget situation switched from a $107 billion deficit in fiscal 1996 to a $236 billion surplus in 2000, the presumed scarcity of Treasury securities did not appear to have any measurable effect on long-term yields, which remained essentially in the vicinity of 6-6.5%.

There is probably no more spectacular case where the purported connection between supply of government securities and bond yields has been challenged "head-on" than Japan. The country has been running enormous budget deficits for more than a decade now, with its cumulative government debt running above 200% of GDP currently (approximately 3 times higher than that of the U.S.). Still, 10-year JGB yields have remained almost consistently within a 1% to 2% range during most of that period.

In the case of Japan, the answer to the seeming paradox lies in two very important factors: a) the availability of a large domestic pool of savings that sustains a strong demand for government-issued debt, and b) a broadly deflationary environment for most of that period, suggesting that as long as real returns on 10-year JGBs remain within a 1.5% to 2.5% range, domestic investors will remain attracted to such paper at still very low nominal yields.

It is certainly true that differences do exist between Japan and the U.S. in regards to the fiscal dynamics. Although the first of the above two factors related to Japan's case is not applicable in the case of the U.S, the latter factor is a universal principle driving fixed income investment decisions and is likely to be a pivotal one in shaping the direction of Treasury yields over the next couple of years. If the Fed's handling of the exit strategy and the actual behavior of inflation convey a reassuring message in terms of the overall price outlook as the economic recovery gathers momentum, the back-up in yields should be relatively moderate- almost irrespective of the amount of new supply; the unique qualities of liquidity and depth that the U.S. Treasury market possesses should remain attractive in the eyes of foreign investors

To be sure, significant changes in the supply situation can very well influence appreciably market psychology for some time and add to a potential setback that yields could suffer in the midst of an economic recovery that is still likely to show more life than had been generally assumed until a couple of months ago. But supply alone is unlikely to become the defining driving force for any sustainable period of time, if a number of other key elements of the underlying fundamentals continue to make Treasury securities an appealing place to be.

None of the above is meant to imply that large budget deficits do not matter at all, as they continue to increase the reliance of this country on foreign sources of financing, with all of the associated potential (at least, in theory) unpredictability; it furthermore continues to add to the national debt, which, at least on common sense grounds, does represent a disconcerting imbalance. But, supply, per se, has been wildly overestimated as a factor that can determine the direction of Treasury yields for any sustained period of time.

Anthony Karydakis