Treasury Yields, Valuation of Risk Financial Assets, Regulation and the Economy

Treasury Yields, Valuation of Risk Financial Assets, Regulation and the Economy

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011

The objective of this post is to relate Treasury yields to valuation of risk financial assets and regulation. The content is as follows:

I Treasury Yields

II Valuation of Risk Financial Assets

III Regulation

IV Economic Indicators

V Interest Rates

VI Conclusion

Appendix: quantitative easing and portfolio allocation

References

I Treasury Yields. The yield of the 10-year Treasury note is shown in the first column of Table 1 at the close of market in selected dates. The objective of the exercise is to compare the price calculated for a security at that yield with coupon of 2.625 percent paid semiannually, maturing exactly in ten years, with the actual price of the 10-year Treasury note on Nov 4, paying coupon of 2.625 percent semiannually and maturing on Nov 15, 2020. The fourth column shows the percentage change in price that would occur at the yields on column two relative to the price on Nov 4. The highest yield in the decade occurred on May 1, 2001, 5.51 percent, for a loss of principal of 22.9 percent relative to the price on Nov 4, one day after the announcement of the Federal Open Market Committee (FOMC) on Nov 3 of further quantitative easing (http://federalreserve.gov/newsevents/press/monetary/20101103a.htm):

“The Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month”

After the recent episode of extremely low interest rates of 1 percent in 2003-2004, bordering the so-called “zero bound,” the yield of the 10-year Treasury backed up from 3.112 percent on Jun 20, 2003, to 5.297 percent on Jun 12, 2007, for a price loss of 17.1 percent or 21.5 percent relative to the price on Nov 4, 2010, as shown in Table 1. The only exit from this policy is in the form of sharp increases in interest rates with likely adverse effects on the financial system and the overall economy.

Table 1, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note

Date	Yield	Price	∆% 11/04/10
05/01/01	5.510	78.0582	-22.9
06/10/03	3.112	95.8452	-5.3
06/12/07	5.297	79.4747	-21.5
12/19/08	2.213	104.4981	3.2
12/31/08	2.240	103.4295	2.1
03/19/09	2.605	100.1748	-1.1
06/09/09	3.862	89.8257	-11.3
10/07/09	3.182	95.2643	-5.9
11/27/09	3.197	95.1403	-6.0
12/31/09	3.835	90.0347	-11.1
02/09/10	3.646	91.5239	-9.6
03/04/10	3.605	91.8384	-9.3
04/05/10	3.986	88.8726	-12.2
08/31/10	2.473	101.3338	0.08
10/07/10	2.385	102.1224	0.8
10/28/10	2.658	99.7119	-1.5
11/04/10	2.481	101.2573	-
11/15/10	2.964	97.0867	-4.1
11/26/10	2.869	97.8932	-3.3
12/03/10	3.007	96.7241	-4.5
12/10/10	3.324	94.0982	-7.1
12/15/10	3.517	92.5427	-8.6
12/17/10	3.338	93.9842	-7.2
12/23/10	3.397	93.5051	-7.7
12/31/10	3.228	94.3923	-6.7

Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates

Source:

http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020

The policy of massive purchases of securities by the Fed known as quantitative easing has bloated the Fed balance sheet. On Dec 29, 2010, “Reserve Bank credit” in the Fed balance sheet was $2403.4 billion, or $2.4 trillion, with a portfolio of long-term securities of $2131.1 billion, or $2.1 trillion, composed of $943.4 billion of notes and bonds, $48.1 billion of inflation-indexed notes and bonds, $147.5 billion of federal agency debt securities and $992.1 billion of mortgage-backed securities; the reserves balances of depository institutions at the Fed were $1027.3 billion (http://federalreserve.gov/releases/h41/current/h41.htm#h41tab1). Reserves of depository institutions at the Federal Reserve Banks rose from $45.6 billion in Aug 2008 to $1084.8 billion in Aug 2010, not seasonally adjusted, multiplying by 23.8 times, or to $1038.2 billion in Nov 2010, multiplying by 22.8 times. The monetary base consists of the monetary liabilities of the government, composed largely of currency held by the public plus reserves of depository institutions at the Federal Reserve Banks. The monetary base not seasonally adjusted, or issue of money by the government, rose from $841.1 billion in Aug 2008 to $1991.1 billion or by 136.7 percent and to $1968.1 billion in Nov 2010 or by 133.9 percent (http://federalreserve.gov/releases/h3/hist/h3hist1.pdf). Policy can be viewed as creating government monetary liabilities that ended mostly in reserves of banks deposited at the Fed to purchase $2.1 trillion of long-term securities or assets, which in nontechnical language would be “printing money” (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). The marketable debt of the US government in Treasury securities held by the public stood at $8.7 trillion on Nov 30, 2010 (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds112010.pdf). The current holdings of long-term securities by the Fed of $2.1 trillion, in the process of converting fully into Treasury securities, are equivalent to 24 percent of US government debt held by the public, and would represent 29.9 percent with the new round of quantitative easing if all the portfolio of the Fed, as intended, were in Treasury securities. Debt in Treasury securities held by the public on Dec 31, 2009, stood at $7.2 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds122009.pdf), growing to Nov 30, 2010, by $1.5 trillion or 20.8 percent.

There are three important issues with respect to quantitative easing: (1) the reasons for quantitative easing and intended objectives; (2) the movement of Treasury yields; and (3) the analysis of factors of failure or success of the policy. The first two are discussed in this section while the third is discussed in the following section on “valuation of risk financial assets.” First, reasons and objectives of quantitative easing. The statement of the FOMC on Nov 3 reveals the reasons for quantitative easing (http://federalreserve.gov/newsevents/press/monetary/20101103a.htm):

“Information received since the FOMC met in September confirms that the pace of recovery in output and employment continues to be slow. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated and measures of underlying inflation are somewhat low, relative to levels that the committee judges to be consistent, over the long run, with its dual mandate”

The FOMC added a new first phrase to its statement at the meeting on Dec 14: “information received since the FOMC met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment” (http://federalreserve.gov/newsevents/press/monetary/20101214a.htm). A complementary policy was begun on Dec 16, 2008 as revealed by the statement of the FOMC meeting: “The FOMC decided today to establish a target range for the federal funds rate of 0 to ¼ percent” (http://federalreserve.gov/newsevents/press/monetary/20081216b.htm). An important channel of transmission of quantitative easing is that “if money is an imperfect substitute for other financial assets, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. In turn, lower yields on long-term assets will stimulate economic activity” (Bernanke and Reinhart (2004, 88), cited in Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 158, Regulation of Banks and Finance (2009b), 224). The commitment of the Fed to purchasing long-term securities is designed to impress on investors that prices will increase and yields decline for asset classes that are related to long-term borrowing costs of firms, such as corporate debt and asset-backed securities collateralized with loans that generate funding for loans to small and medium enterprises and purchases of consumer durables by the public. The success or failure of this mechanism is discussed in the following section II.

Second, the movement of Treasury yields. The yield of the 10-year Treasury note, as shown in Table 1, has risen from 2.481 percent on Nov 4, a day after the statement of the FOMC, to 3.228 percent on Dec 31 with a high of 3.517 percent on Dec 15. Economists and market participants consider some five explanations of the upward trend of Treasury yields that are likely interrelated: (1) anticipations of faster economic growth revealed by short-term economic indicators suggest that the Fed may need to reverse its monetary easing earlier than intended such that higher fed funds rates may raise the yields of Treasury securities and other fixed-income securities; (2) inflation could return, as with the rise of consumer price inflation from 1.9 percent in 2003, when the Fed first feared deflation, to 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), with the Fed raising fed funds rates from 1 percent in Jun 2004 to 5.25 percent in Jun 2006 and 10-year Treasury yields rising from 3.112 percent on Jun 10, 2003, to 5.297 percent on Jun 12, 2007; (3) high budget deficits and unsustainable government debt may cause higher yields required by investors to place new debt, refinancing maturing debt and financing interest payments; (4) the unwinding of the Fed balance sheet with the Fed selling its huge portfolio could set up pressure on interest rates, including raising rates paid on reserves held by depository institutions at the Federal Reserve Banks that would raise funding costs of banks and ultimately lending rates; and (5) the upward trend of Treasury yields may accelerate as investors move funds away from fixed-income securities toward equities and commodities.

II Valuation of Risk Financial Assets. What happened in reality was different from the intentions of quantitative easing. The appendix covers relevant analysis of valuation of risk financial assets in technical literature. There was a first episode of quantitative easing with very low interest rates after 2002. The Fed feared deflation and lowered fed funds rates to 1 percent in Jun 2003, leaving them at that level until Jun 2004. This encouraged a carry trade of borrowing at short-term rates because they were significantly lower than long-term rates. Readily convertible funds were remunerated by very low short-term rates, inducing minimal liquidity. The objective of the Fed was to encourage low borrowing costs, inducing borrowing for investing in production and buying consumer durables. The objective of the “easy monetary policy” was to encourage “easy lending” (see the effects on Florida real estate in http://professional.wsj.com/article/SB10001424052748703326204575616340542578852.html?mod=WSJ_RealEstate_LeftTopNews&mg=reno-wsj) that intentionally made home buying more affordable to force higher economic growth. Home buyers decided on the basis of lower monthly payments, disregarding the warning in sky-high real estate prices. Leverage is borrowing, which was encouraged by Fed policies with the objective of promoting higher economic growth and employment. Risks were considered low because the Fed would continue providing almost unlimited amounts of dollars at very low interest rates. Credit standards were relaxed, in synchrony with the government policy of affordable housing, because collateral in loans would increase rapidly in value and could be repossessed to pay for the loan principal and interest. The government also encouraged investment in real estate by a yearly housing subsidy of $221 billion, policy of affordable housing and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac. Homebuyers did not look at the high prices of houses but at the affordable monthly payments and the illusion they created that house prices would increase indefinitely. Quantitative easing was in the form of suspension of the auction of 30-year Treasury bonds to encourage purchase of 30-year mortgage-backed securities to increase their price or equivalently lower their yields, with the objective of lowering mortgage rate to encourage refinancing. Inflation did not become negative but rose from 1.9 percent in 2003, for the consumer price index, to 4.1 percent in 2007. The Fed increased the fed funds rate from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. Families, investors and most everybody worldwide were encouraged to benefit from the low interest rates originating in Fed policy and housing policy by borrowing significantly or high leverage, ignoring potential future adverse events or taking high risks, investing fully or having little or no cash assets or low liquidity and taking advantage of easing lending or taking unsound credit decisions. The carry trade of borrowing at extremely low short-term rates and taking long positions in risk financial assets is shown in Table 2 in the form of high valuations in most risk financial assets and then eventual collapse in the form of the credit/dollar crisis and global recession after 2007. The financial crisis and global recession were caused by interest rate and housing policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4).

Table 2, Volatility of Assets

DJIA	10/08/02-10/01/07	10/01/07-3/4/09	3/4/09- 4/6/10
∆%	87.8	-51.2	60.3
NYSE Financial	1/15/04- 6/13/07	6/13/07- 3/4/09	3/4/09- 4/16/07
∆%	42.3	-75.9	121.1
Shanghai Composite	6/10/05- 10/15/07	10/15/07- 10/30/08	10/30/08- 7/30/09
∆%	444.2	-70.8	85.3
STOXX EUROPE 50	3/10/03- 7/25/07	7/25/07- 3/9/09	3/9/09- 4/21/10
∆%	93.5	-57.9	64.3
UBS Com.	1/23/02- 7/1/08	7/1/08- 2/23/09	2/23/09- 1/6/10
∆%	165.5	-56.4	41.4
10-Year Treasury	6/10/03	6/12/07	12/31/08	4/5/10
%	3.112	5.297	2.247	3.986
USD/EUR	7/14/08	6/03/10	8/13/10
Rate	1.59	1.216	1.323
New House	1963	1977	2005	2009
Sales 1000s	560	819	1283	375
New House	2000	2007	2009	2010
Median Price $1000	169	247	217	203

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://www.census.gov/const/www/newressalesindex_excel.html

The current episode of zero interest rates and quantitative easing is not characterized by “sitting” on carry trades over long periods as in 2003-2007, which is documented in Table 2. The recovery in 2010 has been characterized by bouts of risk aversion caused by three interrelated factors, occurring simultaneously in some periods: (1) sovereign risk issues in Europe with multiple linkages through banks, securities and trade spreading across various regions; (2) doubts on continuing high rates of growth in China affecting commodities markets and the world economy through trade and financial markets; and (3) lower rates of economic growth in the US than in earlier cyclical expansions, causing continuing job stress of 26.4 million people. Risk aversion rose sharply after the sovereign risk issues in Europe in Apr. Values of key financial assets declined sharply until around early Jul, as shown in Table 3, which is updated with every post of this blog. The column “∆% to Trough” in Table 3 shows deep contraction of financial variables caused by risk aversion provoked by the European risk issues from Apr to around Jul 2 for most assets. The column “∆% Peak to 12/31” shows the percentage changes from the peak around Apr 26 to Dec 31, providing evidence that recovery from the last peak has not occurred for all financial assets. The final column “∆% Trough to 12/31” shows the percentage changes from the trough, around Jul 2 for many assets, to Dec 31. This last column shows that the 0 to ¼ percent fed funds rate together with insinuations by members of the FOMC after Aug of another round of quantitative easing resulted in the depreciation of the dollar by 12.6 percent, actually higher but reversed more recently, together with the sharp increase in almost all values of world financial assets. This is, essentially, the repetition of the effects of the earlier zero interest rate policy cum quantitative easing but on markets and individuals who learned from the earlier experience and manage positions with high frequency. There is no painless exit strategy by the Fed from this policy without another financial event that could spread to the overall economy.

Table 3, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 12/31	∆% Week 12/31	∆% Trough to 12/31
DJIA	4/26/10	7/2/10	-13.6	3.3	0.03	19.5
S&P 500	4/23/10	7/20/10	-16.0	3.3	0.06	22.9
NYSE Finance	4/15/10	7/2/10	-20.3	-7.1	0.6	16.6
Dow Global	4/15/10	7/2/10	-18.4	0.01	0.4	22.5
Asia Pacific	4/15/10	7/2/10	-12.5	7.9	1.9	23.2
Japan Nikkei Average	4/05/10	8/31/10	-22.5	-10.2	-0.5	15.9
China Shanghai	4/15/10	7/02/10	-24.7	-11.3	-0.9	17.8
STOXX 50	4/15/10	7/2/10	-15.3	-4.6	-2.5	12.6
DAX	4/26/10	5/25/10	-10.5	9.2	-2.0	21.9
Dollar Euro	11/25 2009	6/7 2010	21.2	11.6	-1.9	-12.2
DJ UBS Comm.	1/6/10	7/2/10	-14.5	11.9	2.2	30.9
10-Year Tre.	4/5/10	4/6/10	3.986	3.397

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

Source: http://online.wsj.com/mdc/page/marketsdata.html

An important characteristic of world financial assets is that while most risk financial assets have shown high increases in 2010 and 2009, valuations, with the exception of commodities, are still significantly below 2007 levels. Table 4 provides the percentage change of valuations of equities and commodities (by the Dow Jones UBS Commodities Index) at year-end 2010 relative to values at year-end in 2009, 2008, 2007 and 2006. Most financial assets have not recovered earlier levels. The interest rate of 0 to ¼ percent cum quantitative easing have not been as effective as after 2003 in inflating world financial assets because market participants are less credulous than assumed in crafting statements of the FOMC.

Table 4, Percentage Change of Year-end 2010 Values of Financial Assets Relative to Year-end Values 2006-2009

	2009	2008	2007	2006
DJIA	11.0	31.9	-12.7	-7.4
S&P 500	12.8	39.2	-14.3	-11.7
NYSE Fin	5.0	28.8	-40.3	-48.3
Dow Global	4.6	36.8	-25.5	-2.5
Dow Asia-P	15.9	58.2	-11.7	0.8
Nikkei Av	-3.0	16.9	-33.2	-40.4
Shanghai	-11.9	53.2	-46.6	9.4
STOXX 50	-0.1	28.3	28.8	-30.4
DAX	16/1	43.7	-14.3	4.6
USD/EUR	6.7	3.9	8.4	-0.9
DJ UBS Com	16.7	38.5	-12.2	-2.3

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

Another common analysis is that equities declined because of the flight of funds away from the stock market into the safety of bond markets and surged again when investors dumped bonds in exchange for equities. This appears to be the case for retail investors in mutual funds. The Investment Company Institute (ICI) estimates fund inflows into equity mutual funds of $3.9 billion in the week of Dec 21 of which $3.6 billion to funds in foreign equities and $335 million into funds in domestic equities. There was an outflow of total bond funds of $4.4 billion of which $3.5 billion in municipal bond funds and $837 million in taxable bond funds (http://www.ici.org/research/stats/flows/flows_12_29_10). In the first eleven months of 2010, net cash outflows of stock mutual funds were $29.6 billion compared with net cash outflows of $5.5 billion in the first eleven months of 2009. Taxable bond mutual funds received $241.9 billion of net cash inflows in the first eleven months of 2010 compared with $285.6 billion in the first eleven months of 2009 while municipal bond mutual funds received net cash inflows of $24.6 billion in the first eleven months of 2010 compared with $64.4 billion in the same period in 2009 (http://www.ici.org/research/stats/trends/trends_11_10). Total net assets of stock mutual funds stood at $5324.8 billion in Nov 2010 for an increase of 7.4 percent relative to $4958.5 billion in Dec 2009 while the total net assets of taxable bond funds decreased by 14.7 percent from $2918.4 billion in Dec 2009 to $2488.4 billion in Nov 2010 (http://www.ici.org/research/stats/trends/trends_11_10). The monthly data of the ICI show heavy net outflows of stock mutual funds following the sovereign debt risks in Europe: -$24.8 billion in May, -$5.8 billion in Jun, -$10.6 billion in Jul, -$16.6 billion in Aug and -10.7 billion in Sep with reversal to net inflows of $441 million in Oct and $3.9 billion in Nov. In contrast, there were heavy monthly inflows into taxable and municipal bond funds through the first ten months of 2010 interrupted by the outflows in Nov of total bond funds of $4.4 billion of which $3.5 billion in municipal bond funds and $837 million in taxable bond funds. Table 5 provides the percentage change of the DJIA and S&P 500 after Apr 26 both relative to the earlier date and relative to Apr 26. The DJIA has increased by only 3.3 percent over the value on Apr 26 and the S&P 500 has increased by only 3.8 percent. Comments are frequently made that stock prices embody future economic growth. That would require almost perfect foresight while economic forecasts are second to those of astrologers. It is quite difficult to separate effects of allocation of funds to equities because of the low returns of bonds from allocations caused by optimism about economic recovery. There is a problem similar to that of separating the multiple effects of the causes of higher Treasury yields and resulting capital losses.

Table 5, Percentage Changes of DJIA and S&P 500 in Selected Dates

2010	∆% DJIA from earlier date	∆% DJIA from Apr 26	∆% S&P 500 from earlier date	∆% S&P 500 from Apr 26
Apr 26
May 6	-6.1	-6.1	-6.9	-6.9
May 26	-5.2	-10.9	-5.4	-11.9
Jun 8	-1.2	-11.3	2.1	-12.4
Jul 2	-2.6	-13.6	-3.8	-15.7
Aug 9	10.5	-4.3	10.3	-7.0
Aug 31	-6.4	-10.6	-6.9	-13.4
Nov 5	14.2	2.1	16.8	1.0
Nov 30	-3.8	-3.8	-3.7	-2.6
Dec 17	4.4	2.5	5.3	2.6
Dec 23	0.7	3.3	1.0	3.7
Dec 31	0.03	3.3	0.07	3.8

Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004

A set of policies to steer the economy away from high unemployment, zero interest rates and threatening deflation would consist of (Svensson 2003, 161):

“(1) an upward-sloping price-level target path, starting above the current price level by a price gap to undo; (2) a depreciation and a crawling peg of the currency; and (3) an exit strategy in the form of abandonment of the peg in favor of inflation or price-level targeting when the price-level target path has been reached”

Dollar devaluation is an important mechanism for increasing the rate of economic growth that would reduce unemployment as well as increasing prices that would eliminate the threat of deflation.

Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):

“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”

Table 6, updated with every post of this blog, provides the movement of world exchange rates during relevant periods. The dollar has devalued relative to most currencies and devaluation has accelerated after the new round of quantitative easing. It is difficult to isolate the effects of quantitative easing from economic conditions and domestic policies in individual countries that also contribute to relative exchange rate movements.

Table 6, Exchange Rates

	Peak	Trough	∆% P/T	Dec 31 2010	∆% T Dec 31	∆% P Dec 31
EUR USD	7/15 2008	6/7 2010		12/31 2010
Rate	1.59	1.192		1.338
∆%			-33.4		10.9	-29.9
JPY USD	8/18 2008	9/15 2010		12/31 2010
Rate	110.19	83.07		81.10
∆%			24.6		2.4	26.4
CHF USD	11/21 2008	12/8 2009		12/31 2010
Rate	1.225	1.025		0.932
∆%			16.3		9.1	23.9
USD GBP	7/15 2008	1/2/ 2009		12/31 2010
Rate	2.006	1.388		1.561
∆%			-44.5		11.1	-28.5
USD AUD	7/15 2008	10/27 2008		12/31 2010
Rate	0.979	0.601		1.023
∆%			-62.9		41.3	4.3
ZAR USD	10/22 2008	8/15 2010		12/31 2010
Rate	11.578	7.238		6.62
∆%			37.5		8.5	42.8
SGD USD	3/3 2009	8/9 2010		12/31 2010
Rate	1.553	1.348		1.283
∆%			13.2		4.8	17.4
HKD USD	8/15 2008	12/14 2009		12/31 2010
Rate	7.813	7.752		7.773
∆%			0.8		-0.3	0.5
BRL USD	12/5 2008	4/30 2010		12/31 2010
Rate	2.43	1.737		1.661
∆%			28.5		4.3	31.6
CZK USD	2/13 2009	8/6 2010		12/31 2010
Rate	22.19	18.693		18.666
∆%			15.7		0.1	15.9
SEK USD	3/4 2009	8/9 2010		12/31 2010
Rate	9.313	7.108		6.707
∆%			23.7		5.6	27.9

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

III Regulation. Dodd-Frank created the Financial Stability Oversight Council (Sec. 111 (a) http://docs.house.gov/rules/finserv/111_hr4173_finsrvcr.pdf 32). The main purpose and duty of the council is “to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace” (http://docs.house.gov/rules/finserv/111_hr4173_finsrvcr.pdf Sec. 112 (a)(1)(A), 37). Much the same as what is revealed in the transcripts of FOMC meetings will happen with the systemic risk oversight council: lack of precise knowledge on what to do with regulatory powers. Banks that are viable in their present form may not be viable when dismembered of lines of business. The financial system may suffer crisis stress when the dismembering or even closing of one bank affects other banks that are large, medium or small and even the entire financial system. Amputations of business lines of key players in the financial system without precise science may well trigger the “systemic” crisis that Dodd-Frank intends to prevent. Turmoil in financial markets and bank stocks during risk aversion episodes created unpleasant memories of declines of stock prices of large financial institutions toward zero. Frustration of innovative risk management techniques will create more unstable financial institutions, depending on pure lending. Banks could not transfer fully risk by securitization of loans and mortgages becoming more vulnerable to credit risk by the requirement of holding part of the loans in their balance sheets.

Three important articles based on research by the Wall Street Journal provide evidence on the difficulty of identifying the financial soundness of even smaller banks (http://professional.wsj.com/article/SB10001424052970204685004576045912789516274.html?mod=WSJPRO_hps_LEFTWhatsNews http://professional.wsj.com/article/SB10001424052970203568004576044014219791114.html?mod=WSJPRO_hps_LEFTWhatsNews http://professional.wsj.com/article/SB10001424052970204527804576044380128768272.html?mod=WSJPRO_hps_LEFTWhatsNews). The Treasury Troubled Asset Relief Program (TARP) intended to provide help only to solvent banks. The Wall Street Journal has identified 98 banks that received combined TARP funds in excess of $4.2 billion that have inadequate capital levels, large volumes of bad loans and regulatory warnings. Over $2.7 billion of TARP funds have been lost because of failures by recipient institutions. The TARP banks in difficulties are small and have loans that do not suggest they will recover. On Sep 30, the median size of the 98 banks was $439 million with median funding by TARP of $10 million. In contrast, the first eight banks and brokerages that received TARP injections in the value of $125 billion have all repaid the funds. The FDIC has significant difficulty in identifying small banks with unsophisticated transactions that will fail from those that survive. The Wall Street Journal identifies about a dozen failing institutions of 300 that failed in the US in 2010 that had tangible common equity ratio of 8 percent of risk-weighted assets, which would be an indicator of relatively healthy conditions, while 50 banks that failed had negative capital at the time of government intervention, which means losses had wiped out capital (http://professional.wsj.com/article/SB10001424052970204685004576045912789516274.html?mod=WSJPRO_hps_LEFTWhatsNews). If deciding the timing of resolving small banking institutions with assets of a few hundred million dollars is not feasible, the endeavor of timing dismembering or resolution of US banks with highly complex balance sheets in international operations with assets over a trillion dollars and equity of hundreds of billions of dollars is entirely unfeasible. Dodd-Frank’s Financial Stability Oversight Council should be abandoned in favor of risk management by the Federal Reserve System, which has mandate in its mission for “maintaining the stability of the financial system and containing systemic risk that may arise in financial markets” (http://federalreserve.gov/aboutthefed/mission.htm).

IV Economic Indicators. The Chicago purchasing managers’ index (PMI) for Dec 2010 is the strongest economic indicator in the current expansion phase; it is considered a leading indicator of the national Institute for Supply Management (ISM) index to be released on Jan 3. House prices and sales continue to be at recession levels and labor markets continue to be weak. The Business Barometer index of the Chicago ISM jumped from a seasonally adjusted level of 62.5 in Nov to 68.6 in Dec for the highest level since Jul 1988. Individual components show robust growth. Production rose from 71.3 in Nov to 74.0 in Dec, which is the highest level since Oct 2004. New orders jumped from 67.2 in Nov to 73.6 in Dec, which is at the level of 2005. Employment rose from 56.3 in Nov to 60.2 in Dec, which is the highest level in more than five years. The order backlogs index jumped from 48.9 in Nov, below the border of contraction at 50, to 64.6 in Dec, signaling that companies may expand to meet orders. Prices paid rose from 70.7 in Nov to 78.2 in Dec for the highest level since Jul 2008 (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20December%202010.pdf). The official purchasing managers’ index (PMI) of China fell from 55.2 in Nov to 53.9 percent in Dec, which is the first drop in five months. New orders fell from 58.3 in Nov to 55.4 in Dec. A manufacturing index surveyed by HSBC also fell in Dec for the first time in five months (http://www.bloomberg.com/news/2011-01-01/china-manufacturing-growth-slows-as-interest-rates-rise-to-curb-inflation.html). While the economy of China may have grown by 10 percent in 2010, inflation accelerated to 5.1 percent in the 12 months ending in Nov and the government has increased interest rates and taken other restrictive measures on lending and property prices. The SP Case-Shiller index of home prices registered declines in all 20 metropolitan areas surveyed from Sep to Oct following similar declines from Aug to Sep. The 10-metropolititan area composite rose 0.2 percent in Oct 2010 from Oct 2009 but the 20-metropolitan area composite fell by 0.8 percent in the same period. The only gains in Oct 2010 relative to Oct 2009 were in the 10-metropolitan area composite by only 0.2 percent and in the indexes for Los Angeles, 3.3 percent, San Diego, 3.0 percent, San Francisco, 2.2 percent, and Washington DC, 3.7 percent. Composite house prices are still higher than the troughs in the spring of 2009 but there are new lowest levels for home prices since 2006-2007 in six metropolitan areas—Atlanta, Charlotte, Miami, Portland (OR), Seattle and Tampa—that have suffered new troughs since the spring of 2009 (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----). The pending home sales index of the National Realtors Association, measuring contracts signed in Nov 2010, rose 3.5 percent but is 5.0 percent lower than the estimate for Nov 2009 (http://www.realtor.org/press_room/news_releases/2010/12/pending_gradual). Seasonally adjusted initial claims for unemployment insurance increased by 34,000 to 388,000 in the week ending Dec 25 compared with revised 422,000 a week earlier. The 4-week moving average fell 12,500 to 414,000 in the week ending Dec 25 compared with 426,500 a week earlier. There is significant difference with initial claims not seasonally adjusted that increased by 24,879 to 521,834 in the week ending on Dec 25 compared with 496,955 in the week ending on Dec 18. Initial claims seasonally adjusted are lower by 66,000 relative to 454,000 a year earlier and not seasonally adjusted are lower by 34,683 relative to 556,517 a year earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm). The total number of “persons claiming unemployment insurance benefits in all programs” is 8,886,924 in the week ending on Dec 11, which is lower by 1.9 million than 10,787,906 a year earlier. The Wall Street Journal cautions that the majority of 4.5 million receiving unemployment insurance are “long-term unemployed” because they have been without a job for 27 weeks or more, exhausting the 26 weeks of state unemployment benefits and receiving federal benefits for at most 99 weeks (http://professional.wsj.com/article/SB10001424052970204204004576050033091874102.html?mod=WSJPRO_hps_MIDDLEThirdNews). It is far more difficult for the long-term unemployed to find a new job, which may add to “structural” unemployment that may remain even if the economy grows faster. The insured unemployment rate not seasonally adjusted is 3.3 percent for the week ending on Dec 18, or 4,095,135, which is close to 3.9 percent a year earlier or 5,088,864.

V Interest Rates. The 10-year Treasury yield at 3.29 percent on Dec 31 is lower than 3.40 percent a week ago but higher than 2.96 percent a month ago. The 5-year Treasury yield at 2.01 percent on Dec 31 is lower than 2.06 percent a week ago but higher than 1.62 percent a month ago. The 10-year government bond of Germany traded at 2.96 percent on Dec 31 for a negative spread of 33 basis points relative to the comparable Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1293971285416). The 10-year Treasury with coupon of 2.625 percent, maturing on Nov 11, 2020, traded at a price of 94 12/32 or yield of 3.29 percent at the close of market on Dec 31 (http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/).

VI Conclusion. There is a national institutional event, the widely anticipated results of the legislative elections perhaps interrupting massive rushed legislative restructuring and regulation, which competes with alleged government effects of fiscal/monetary policy in explaining evidence of improving economic activity. The new activity continues to be insufficient to recover employment as during past deep economic contractions. There are continuing frictions to growth in the form of implementation of legislative restructurings and regulation and expectations of higher taxes and interest rates resulting from the trillion dollar deficits, debt growth in an unsustainable path and the unwinding of the Fed balance sheet. An essay by Chairman Bernanke in 1999 on Japanese monetary policy received attention in the press stating that (http://www.iie.com/publications/chapters_preview/319/7iie289X.pdf, 165):

“Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and experiment—in short, to do whatever it took to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done”

Quantitative easing has never been proposed by Chairman Bernanke or other economists as certain science without adverse effects. In his visionary work that anticipated for over two decades general equilibrium analysis of capital accounts or balance sheets, on which quantitative easing is based, Hicks (1935) concludes:

“Lastly, it seems to follow that when we are looking for policies which make for economic stability, we must not be led aside by a feeling that monetary troubles are due to ‘bad’ economic policy, in the old sense, that all would go well if we reverted to free trade and laisser-faire. In so doing, we are no better than the Thebans who ascribed the plague to blood-guiltiness, or the supporters of Mr. Roosevelt who expect to reach recovery through reform. There is no reason why policies which tend to economic welfare, statically considered, should also tend to monetary stability. Indeed, the presumption is rather the other way around”

The needed change of course is toward more sober evaluation of economic policy and institutional reform without the experimental rushed wide swings of the past few years. Government policy and regulation can promote economic growth when designed more wisely than has been the case recently. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

Appendix: quantitative easing and portfolio allocation

The general equilibrium model of capital asset market prices considers a large number of m individuals choosing portfolio shares of many n capital assets on the basis of n rates of return of different assets (Mossin 1966, 679-33; Hicks 1935, 1962; Treynor 1962; Tobin 1958, 1961, 1969; Sharpe 1964; Lintner 1965). Each individual has a portfolio consisting of proportionate shares of the n capital assets. Asset returns include interest and capital gains or losses. Asset returns and portfolios are random variables. Each individual is assumed to behave as if maximizing a utility function, U, depending on expected yields, μ_p, and standard deviations of yields, σ_p, or U(μ_p, σ_p). The resulting allocation is Pareto optimal as it is the case of Walrasian general equilibrium systems (Arrow 1951, Debreu 1951; see Duffie and Sonnenschein 1988). Thus, the model assumes perfect competition with all the individual assumptions or lack of frictions. Portfolio weights are chosen to reach a point on the efficient frontier. The rule of Markowitz (1952, 82) states that “investors would (or should) want” to choose a portfolio of combinations of (μ_p, that are efficient, which are those with minimum variance or risk for given expected return μ_p or more and maximum expected μ_p for given variance or risk or less. An important introduction is the riskless or “pure” rate of interest, r_f. Individuals choose portfolio weights to find the point on the efficient portfolio that is attainable by the market line relating expected return and risk. The optimum point is found at the tangency of the market line and the highest attainable indifference curve. The individual can borrow or lend at the riskless rate and choose weights or proportionate shares of risk financial assets to reach the Markowitz efficient portfolio.

The riskless rate affords the opportunity of carry trades such as borrowing at the short-term interest rate and choosing the combination of risk portfolio assets that results in the efficient portfolio. There are the common doubts in all economics that the assumptions of perfect competition are not likely to be found in reality. Finding empirically a second-best solution may prove quite difficult (Lipsey and Lancaster 1956-1957). There is an added problem that not all the rates of return in the general equilibrium model of capital asset prices are observable (Roll 1977). Portfolio reallocation after a shock to the system such as quantitative easing would cause investors to reshuffle their weights in the movement toward the efficient portfolio. In the case of quantitative easing, there is no theoretical presumption that investors would choose higher weights of Treasury securities and that simultaneously or subsequently would also choose higher weights of private-sector debt securities, corporate bonds and asset-backed securities, which would cause significant lowering of the costs of borrowing for investing to produce or lowering costs of borrowing to buy consumer durable goods. The menu of potential assets includes all risk financial assets such as commodities, equities, emerging-market securities, currencies, junk bonds and so on. The 0 to ¼ percent fed funds rate encourages carry trade of borrowing in dollars at very low rates, shorting the dollar and taking long positions worldwide in risk financial assets.

References

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Pelaez, Carlos M. and Carlos A. Pelaez. 2008b. Globalization and the State: Vol. II. Basingstoke: Palgrave Macmillan.

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Pelaez, Carlos M. and Carlos A. Pelaez. 2009a. Financial Regulation after the Global Recession. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2009b. Regulation of Banks and Finance. Basingstoke: Palgrave Macmillan.http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

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© Carlos M. Pelaez, 2010, 2011