The Fed leverages up

Ben Bernanke, head of the world's largest hedge fund (aka The Federal Reserve), last week announced that next year he plans to borrow another $1 trillion dollars—on top of the $1.5 trillion he's borrowed over the past four years—in order to fund the federal government's CY 2013 deficit and give his shareholders (aka taxpayers) a profit to boot. This plan is otherwise known as QE4.

His is a unique business, since he can force the market to lend him money—he simply buys what he wants and pays for it with his "bank reserve checkbook." By the end of next year, the Fed will own $1 trillion more bonds, and the banking system will have $1 trillion more reserves, whether it wants them or not. Bernanke can also dictate the rate at which he borrows money; for the foreseeable future that will be the rate the Fed decides to pay on reserve balances held at the Fed, currently 0.25%. Those who end up with the reserves will have essentially lent the Fed money on the Fed's terms.

To be more specific: Next year, Bernanke plans to make net purchases of $540 billion of longer-term Treasuries, and $480 billion of MBS. He will fund those purchases by issuing $1.02 trillion of newly-minted bank reserves. In effect, the Fed will be swapping reserves (which are functionally equivalent to 3-mo. T-bills, the paragon of risk-free assets, but which currently pay a slightly higher rate of interest) for bonds. Since money and bank reserves are fungible, Bernanke's planned purchases should effectively cover Treasury's deficit next year, which, perhaps not coincidentally, looks to be about $1 trillion.

It's important to note here that when the Fed issues $1 trillion of bank reserves, it is NOT "printing money." That's because bank reserves are not cash and they can't be spent anywhere: like pajamas, they are only for use "in house," since they are always kept at the Fed. Bank reserves do have a unique feature, of course, that other short-term assets don't: they can be used by banks to create new money, and in fact, acquiring more reserves is the only way that banks can increase their lending, because banks need reserves to back their deposits. Since banks now hold $1.6 trillion of reserves, of which only $0.1 trillion is required to back current deposits, banks already have an almost unlimited ability to make new loans and thereby expand the money supply. A year from now they will have an even more unlimited ability to do so.

That banks haven't yet engaged in a massive expansion of lending activity and the money supply is a testament only to the risk-averse nature of bank management and the risk-averse nature of the public, which now holds $6.5 trillion of bank savings deposits (up 64% in the past four years) paying almost nothing. As the above chart shows, in recent years the M2 measure of money supply has grown only slightly faster than its long-term average.

To put it another way: The Fed's massive provision of reserves to the banking system has not resulted in an equally large increase in inflation because the world's demand for money (cash, bank deposits, and cash equivalents like bank reserves and T-bills) has been very strong. Banks, in short, have been content to sit on $1.5 trillion of "excess" reserves because they worry that making more loans and increasing deposits might be a lot riskier.

The rationale for hedge funds is to exploit arbitrage opportunities, buying one thing and selling or borrowing another. Even small differences in prices can become lucrative, thanks to the use of lots of leverage. If done successfully, arbitrage can contribute to market efficiency, which in turn can contribute to the health of an economy. Whether the Fed will accomplish the same thing with QE4, however, is an open question. Will banks lend a lot more next year, even though they have an essentially unlimited capacity to lend today? Will increased bank lending fuel genuine economic growth, or will it just fuel more speculation? No one knows. We are in uncharted waters; what the Fed is doing today has never been done before.

When faced with issues of daunting complexity and with little or no guidance from the past, one can only begin by trying to reduce things to their simplest form. Here's what I think is a simplified description of what the Fed is planning: Next year the Fed will be purchasing a total of $1 trillion of 10-yr Treasuries and current coupon MBS. 10-yr Treasuries currently yield 1.75%, and current coupon MBS about 2.25%, so the Fed will earn roughly 2.0% on its purchases, while paying out 0.25% on the reserves it creates to buy those bonds, for a net spread of 1.75%. By the end of next year, the Fed will be raking in $17.5 billion per year in profits on their $1 trillion swap, and that will make the Fed the envy of all other hedge fund managers.

These profits, of course, are automatically remitted by the Fed to Treasury. Happily for taxpayers, those profits will completely offset Treasury's cost of borrowing, at least for the next several years. Here's the math, also in simplified form: First, let's assume that Treasury is funding its deficit with 7-yr Treasuries (that's a decent approximation, since last year they told us that they were going to lengthen the average maturity of outstanding Treasuries, which at the time was about six years). The yield on 7-yr Treasuries is currently about 1.25%, so Treasury will pay 1.25% on $1 trillion, and receive back from the Fed 1.75%, leaving a profit of about 0.5%, or $5 billion. Bottom line, we will all benefit from next year's deficit financing! (Note that the key to the profit is the Fed's decision to buy lots of MBS, which yield more than Treasuries of similar maturity.)

A real-world hedge fund attempting to do the same thing would run up against the reality of mark-to-market accounting rules. If interest rates on the bonds it buys rise, the mark-to-market losses on the bonds could easily wipe out the interest it's receiving, threaten margin calls and ultimately result in insolvency. For example, a 1 percentage point rise in the yield on 7-yr Treasuries would result in a 6.7% decline in their price, thereby wiping out over 5 years' worth of coupon payments. Mortgage-backed securities could fall in price by even more. A hedge fund would also be exposed to the risk that its borrowing costs could rise, thus narrowing or even eliminating the net interest spread it's earning.

Happily, Bernanke doesn't have to worry about any of this, since he doesn't have to mark his bonds to market, and he can keep his borrowing costs below the current yield on his portfolio for at least the next 2 or 3 years, given the FOMC's recent guidance (i.e., it won't start tightening until the unemployment rate falls to 6.5%, short-term inflation expectations exceed 2.5%, and/or long-term inflation expectations become unanchored). And of course, the Fed can always make the interest payments on its borrowings because its "bank reserve checkbook" is effectively bottomless.

If this all sounds too good to be true, it is. The Fed may not face the risks that a typical hedge fund does, but that doesn't mean the Fed is not taking on a huge amount of risk at taxpayers' and citizens' expense. Although the Fed need never face insolvency, if mark to market losses got really bad, they could lose their credibility and with that the value of the dollar could be seriously at risk. The Fed's losses might become direct obligations of Treasury, or they might be inflicted on taxpayers and citizens via the sinister "inflation tax." The Fed could eventually repay its borrowings with devalued dollars, leaving the rest of us with deflated balance sheets and deflated incomes. Meanwhile, by allowing Treasury to borrow trillions at no cost, the Fed is acting as an obstacle to badly needed deficit reduction.

Although it may seem paradoxical, the biggest risk we all face as a result of the Fed's unprecedented experiment in quantitative easing is the return of confidence and the decline of risk aversion. If there comes a time when banks no longer want to hold trillions of dollars worth of excess bank reserves for whatever reason (e.g., the interest rate the Fed is paying is no longer attractive, or the banks feel comfortable using their reserves to ramp up lending, or the public no longer wants to keep many of trillions of dollars in bank savings deposits), that is when things will get "interesting."

More confidence would mean less demand for cash and cash equivalents, and that in turn would mean that a virtual flood of money could try to exit banks (e.g., as people withdraw their savings deposits, and/or borrow more from their banks). If the public attempted to shift trillions in cash into housing, stocks, gold, or other currencies, the consequences would likely be seen in sharply rising prices and higher inflation. Moreover, higher inflation would almost certainly lead to higher interest rates, which in turn would exacerbate the Fed’s mark to market problem and possibly accelerate the whole process. And of course, higher interest rates will result in significantly higher borrowing costs to Treasury, although this will be mitigated to some extent by Treasury's efforts to extend the average maturity of its borrowings.

The Fed reasons that it could deal with declining risk aversion by selling bonds (i.e., reducing bank reserves), not reinvesting principal, and by raising the rate it pays on bank reserves. But it’s not hard to see how things could get out of control: higher rates on bank reserves would likely accelerate the rise in market yields and the mark to market losses on the Fed’s bond holdings, at the same time as its spread eroded. In the meantime, the more bank reserves the Fed creates, the harder it will be to avoid an unhappy outcome.

It’s ironic that the Fed is trying, with QE4, to accomplish the very thing that could be its own undoing. Trying, that is, to encourage more confidence, more lending, more borrowing, more investment, and higher prices for risk assets.

It’s no wonder that the market remains so risk-averse, since this is hardly a comforting position we're in. For now, that is probably a good thing. But in the wake of the election results and the Fed's latest decision, I am less optimistic today than I have been for several years.

Tracking the housing recovery

Markets do have the ability to "look across the valley" and anticipate upcoming changes in the economy. Here are three charts which illustrate how that has happened with onset of the housing market bust and its subsequent recovery.

The first of the above three charts shows the price of lumber futures. Note that prices peaked in 2004, almost two years before the housing market peaked. The second shows an index of home builders' stocks, which peaked in 2005, about a year before the housing market peaked. The third chart shows housing starts, which peaked in early 2006.

As for the housing market recovery, note that lumber futures bottomed in early 2009, home builders' stocks bottomed around the same time, and both lumber futures and home builders' stocks were rising well in advance of the eventual recovery in housing starts, which occurred in mid-2011.

Finally, note that all three indicators are at new post-recession highs. The housing recovery is definitely underway.

This last chart is the Radar Logic measure of housing prices (nonseasonally adjusted). According to this index, prices were up 7.6% in the year ending October 15th. Anecdotally, I continue to see many signs that housing prices have bottomed and are now recovering in many areas of the country. Mark Perry has a nice list here.

UPDATE: Two more charts updated with data released today (12/18/12), both showing continued improvement in the housing market.

UPDATE 2: Below is an updated chart of housing starts, which have soared by 60% since early 2011.

Corporate bonds are moderately attractive

Over the past four years, corporate bonds have delivered total returns that rival those of equities. The S&P 500 has generated a total return of 77%; high-yield bonds (using HYG as proxy) have enjoyed a total return of 101%, for an annualized return of 19%; and investment grade bonds (using LQD as a proxy) have delivered a total return of 55%, or 11.6% annualized. The drivers of this spectacular performance were falling yields and lower-than-expected default rates. 

The chart above shows just how much yields on corporate bonds have declined since late 2008. In retrospect, the late 2008 surge in junk bond yields was a once-in-a-lifetime opportunity for investors willing to take the securities off of the hands of the many investors who were forced to sell at super-depressed levels. Towering yields at the time implied a massive wave of corporate defaults which never materialized, thanks to the recovery—however tepid it has been—and to the Federal Reserve's super-accommodative monetary policy stance.

So: is this the end of the greatest corporate bond rally in history? The chart shows that corporate bond yields are as low as they have ever been, so that is a sign that caution is warranted.

Digging deeper, swap spreads and credit default spreads, shown in the two charts above, suggest that there is still some room for improvement. The level of corporate bond yields is at an all-time low, but corporate bond spreads are still relatively wide. Furthermore, the significant decline in swap spreads suggests that corporate yields and spreads can decline further. If the economy keeps growing at a slow pace, short-term rates remain incredibly low, and monetary policy remains super-accommodative, investors will be all but compelled to continue buying corporate bonds for their still-attractive yields. For example, HYG has an indicated yield today of over 6%, while LQD's yield is almost 4%.

The case for corporate bonds would be bolstered fundamentally by continued improvement in the economy and relatively low default rates. A growing economy and easy money are a perfect recipe for improving corporate cash flows, and that is music to corporate bond investors' ears.

Still, with yields this low, investors should realize that there is a very small cushion against downside risk. If another recession hits, default rates would likely rise in that in turn would erode returns even if interest rates remained very low. If the economy were to strengthen unexpectedly, the Fed would be forced to tighten policy, and that could push corporate bond yields higher, which would also erode returns. It's probably time to start taking some—but not all—of your outsized corporate bond risk off the table, beginning with the investment grade sector.

Full disclosure: I am long HYG at the time of this writing.

Washington needs to control spending, not raise tax rates

Federal government finances have been terribly unbalanced for the past four years, but the good news is that things are looking better, even as we approach the dreaded "fiscal cliff." The budget deficit peaked at $1.47 trillion in December 2009, equivalent to 10.5% of GDP. As of last month, the 12-month deficit had fallen to $1.1 trillion, or about 7% of GDP. That's welcome progress, and it has come about thanks to very slow growth in federal spending and a decent recovery in tax revenues spurred almost entirely by a growing economy.

As the chart above shows, the Great Recession was responsible for a 22% plunge (about $575 billion) in tax revenues. Since 2009, however, revenues have risen 22%, or about $455 billion. From the beginning of the Great Recession through today, federal spending has increased about $800 billion, while tax revenues are down only $120 billion. By far the largest factor driving the budget deficit, therefore, has been the surge in spending. Fortunately, that surge has not continued, but neither has it reversed, whereas the decline in revenues has reversed almost entirely.

As the chart above shows, individual tax receipts are up about $305 billion from the recession lows, accounting for two-thirds of the increase in total revenues. Corporate profits taxes have doubled over the same period, adding $120 billion to total revenues. All of this without any increase in tax rates.

The big message here is that federal revenues are highly sensitive to the health of the economy. They have risen strongly since the recovery began, despite the payroll tax holiday instituted almost two years ago, and revenues are likely to continue to increase as the economy continues to grow. It is spending that is still out of line. If Congress can control the growth of spending going forward, then the budget mess we're in will be resolved without the need for higher taxes on anyone. This is a very important point, since higher tax rates could jeopardize the health of the economy, and that in turn would slow or even reverse the ongoing gains in tax revenue. Balancing the budget only requires that we restrain the growth in spending; going forward, that will be especially important as concerns entitlement spending.

Things are bad, but not as bad as expected

The Eurozone is still in terrible shape, but Eurozone equity prices are up 27% from their June 1st lows. Eurozone equities, in fact, have risen more than twice as much as the S&P 500 over this same period. Are markets turning irrationally exuberant? Not by a long shot.

As I argued in my previous post, with all the bad news and pessimism that's out there, it doesn't make sense to think that markets are even slightly optimistic at current levels. What's happening is that valuations have been so deeply depressed that the market is essentially priced to the expectation of another deep recession—but a recession keeps failing to show up. So even modest growth of 2% or so with continued high unemployment ends up being better than the market expected, and that forces the price of risk assets higher.

Here's a recap of the evidence of pessimistic market sentiment:

Sovereign yields in all developed economies are at extremely low levels. Plus, they are converging with the extremely low yields that have marked Japan's long economic slump. In a sense, the market is saying that the Eurozone and the U.S. economies are destined to suffer the same fate as Japan: prolonged, very weak growth.

Real yields on inflation-indexed bonds are negative. Negative real yields are a strong sign that markets expect very weak growth in the years to come. As the chart above suggests, negative real yields on TIPS are pointing to years of zero growth in the U.S.

PE ratios are below average, even though corporate profits are at record-high levels. This can only mean that the market believes that profits cannot maintain current levels and are almost sure to decline significantly in the years to come.

Earnings yields on equities are substantially higher than corporate bond yields. It's rare for the market to allow earnings yields that are substantially higher than the yield on corporate bonds. Investors are apparently willing to sacrifice a significant amount of earnings yields on stocks in exchange for a much lower yield on corporate bonds, since bonds are senior in the capital structure and thus more secure. In normal environments, equity investors are willing to accept lower earnings yields because they expect future capital gains to more than make up for those low yields. It's also a strong sign of pessimism that investors have stashed $6.6 trillion in bank savings deposits paying almost nothing, when stocks are earning 7%. That huge gap is a good measure of the market's extreme risk aversion today.

Stocks are edging higher because the market is becoming slightly less pessimistic.

Small business optimism plunges

The November report of the National Federation of Independent Business was downright gloomy. I'm feeling gloomy as well, since it's very hard to get optimistic about the future, even if Congress somehow manages to find a compromise to avoid going over the "fiscal cliff." No matter what happens in the next several weeks, it's rational to expect tax burdens, regulatory burdens, and healthcare costs to rise over the next year or so. Entitlement programs, from food stamps to disability to social security and medicare, are going to be consuming an impossible share of our national income within my lifetime unless drastic changes are implemented soon. Yet very few in Washington seem to want to do anything about this, our biggest national problem.

The chart above shows the overall results of the latest survey of small businesses: the Small Business Optimism Index. It fell significantly in November, and is about as weak as it has ever been.

This is a big deal, since small businesses are critically important to the health of the U.S. economy. The Small Business Administration has the relevant stats:

Small businesses make up:
     99.7 percent of U.S. employer firms,
     64 percent of net new private-sector jobs,
     49.2 percent of private-sector employment,
     42.9 percent of private-sector payroll,
     46 percent of private-sector output,
     43 percent of high-tech employment,
     98 percent of firms exporting goods, and
     33 percent of exporting value.

The weakest part of the survey is shown above. As the NFIB reports, "The net percent of owners expecting better business conditions in six months fell 37 points to a net negative 35 percent." This is worse even than in depths of the 2008-2009 Great Recession. Small business owners overwhelming expect business conditions to deteriorate next year.

As the chart above shows, only 5% of small business owners plan to increase hiring. This is up from the Great Recession low, but still substantially below normal levels.

This sums it up:

Something bad happened in November—and based on the NFIB survey data, it wasn’t merely Hurricane Sandy. The storm had a significant impact on the economy, no doubt, but it is very clear that a stunning number of owners who expect worse business conditions in six months had far more to do with the decline in small-business confidence. Nearly half of owners are now certain that things will be worse next year than they are now. Washington does not have the needs of small business in mind. Between the looming ‘fiscal cliff,’ the promise of higher healthcare costs and the endless onslaught of new regulations, owners have found themselves in a state of pessimism.

The only good thing that can be said about all this gloom and doom is that the stock market is undoubtedly suffused with similar gloomy sentiments. Markets are braced for lots of bad news, so if the future turns out to be even slightly less bad than expected, risk asset prices can rise.  

Jobs growth steady but slow

November's jobs report shed no new light on the labor market situation. November's 147K new private sector jobs was in line with what we've been seeing on average for the year to date and for the past three years. It's slightly more than the 130K new jobs per month that need to be created just to keep up with the long-term average growth of the labor force, which is about 1% a year, so if things continue at the same pace the unemployment rate can decline very slowly from here. It's only declined faster because the labor force has grown very little for the past four years, which in turn is a function of many people deciding to "drop out." The current 1.5% per year pace of jobs growth is unlikely to translate into anything more than 3.5% real economic growth, assuming productivity growth continues to run at the 1-2% per year pace we've seen in recent years. That's OK, but it still adds up to the weakest recovery ever.

Note the relatively steady growth of private sector jobs as measured by the Establishment Survey (blue line). Both surveys show that the economy has created about 5 million jobs over the past two years. Also note that there is absolutely no sign here of anything like a recession. Jobs growth may be disappointing, but it is still definitely positive.

After declining from 2008 through early 2011, the labor force has resumed a 1% annual pace of growth over the past year. But it is still more than 5 million below where it could have been if long-term trends were still in place.

The November report provided more confirmation that the public sector workforce is no longer shrinking. Despite declining jobs in the past few years, public sector employees have not suffered nearly as much as their private sector counterparts over the past decade: private sector jobs are only now back to where they were in early 2002, whereas public sector jobs have risen on net by 1 million (almost 5%). It's still the case that  the best job security and the best pay and benefits can be found in the public sector.

Thanks to below-trend growth in the labor force and the relatively tepid growth of jobs, the economy has fallen farther behind its long-term growth trend than at any time in modern history. This is the weakest recovery ever. Fewer people working means the tax base is a lot smaller than it could be, and that is main source of a shortfall in tax revenues. Faster economic growth, powered by faster job creation, is the key to shrinking the fiscal deficit from the revenue side. Raising tax rates will only risk retarding the rate of growth. Are you listening, Mr. Obama?

The Fed is doing all it can to promote faster growth, by purchasing on net about $1.5 trillion worth of MBS and Treasuries in the past four years. So far, however, there is no sign that they have managed to increase the pace of jobs growth. Their main accomplishment has been to satisfy the world's almost insatiable demand for risk-free short-term securities, which in turn has been driven by fear of sovereign defaults, a double-dip recession, the expectation that massive federal deficits will inevitably result in a huge increase in tax burdens, and concerns that monetary stimulus could prove to be very inflationary. As the chart above shows, the market's current expectation for inflation over the next 10 years is 2.5%, which is pretty much average. But it's nowhere near the deflationary levels that most Keynesian models have been predicting given the economy's weak recovery and the unprecedented output gap that currently exists.

The chart above is a more sensitive measure of inflation expectations. The blue line shows that the bond market expects inflation to average a little over 3% during the period 2018-2023. That's not very frightening, but it does suggest that what's driving the rise in equity prices over the past year or so is inflation expectations rather than growth expectations. The Fed has absolutely succeeded in snuffing out any deflationary threat, but instead of boosting jobs growth, they have merely boosted the market's confidence that future cash flows to U.S. businesses will be rising by at least 2.5-3% per year, even if the economy posts very weak growth.

The negative real yields on TIPS, which are at or close to all-time lows, are a clear sign that the market expects future economic growth to be dismal. At the same time, the inflation expectations built into TIPS and Treasury prices say that the market expects inflation to be at least as high in the future as it has been in the past. Growth expectations are falling, while inflation expectations and equities are rising. Translation: equities are behaving more like inflation hedges these days, than like barometers of real growth expectations.

UPDATE: Nobel prizewinner Edward Prescott comes to a similar conclusion regarding the current 13% "output gap" that I show in the fourth chart of this post. See his op-ed in the 12/12/12 edition of the WSJ: "Taxes Are Much Higher than You Think." Increased tax and regulatory burdens, coupled with increased income redistribution schemes, likely explain why the gap is so large.