Recovery without Vigor, Quantitative Easing, Financial Arbitrage of Monetary Policy and Rising Equities

 

Recovery without Vigor, Quantitative Easing, Financial Arbitrage of Monetary Policy and Rising Equities

Carlos M. Pelaez

This post relates monetary policy, financial institutions and the crisis in (I) to further quantitative easing in (II), financial arbitrage of monetary policy in (III), economic indicators in (IV) and interest rates in (V) with conclusion in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Monetary Policy, Financial Institutions and the Crisis. Chairman Bernanke distinguishes economics as a “science” explaining with theory and empirical generalizations the actions of households, institutions, markets and aggregate economies; “economic engineering” as the application of economic knowledge designing measures for solving specific problems; and “economic management” as the actual daily operation of private financial institutions and their public-sector supervision (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm#f15 ). Chairman Bernanke finds that knowledge on the working of the economy was useful in understanding the financial crisis and its consequences even if there were no descriptively accurate predictions of the complex interrelations. Conventional economic policy, such as the Bagehot Principle, or lender of last resort by the Fed, of providing credit to solvent institutions on the basis of sound collateral at punitive rates, was the correct policy (on central banking see Pelaez and Pelaez, Financial Regulation after the Global Recession, 69-90, Regulation of Banks and Finance, 99-116, Globalization and the State Vol. I, 30-43, Government Intervention in Globalization, 31-7, International Financial Architecture, 77-9). Unconventional policy in the form of quantitative easing, or purchases of long-term securities by use of the Fed balance sheet, was also an adequate response to the crisis. The failures were in economic engineering and management. First, economic engineering provided weak measurements and management of risk that together with inadequate business models led to “overreliance on unstable short-term funding and excessive leverage” (Ibid). Regulatory structures were devised for earlier periods, failing to capture risks outside control by supervision such as in the “shadow banking system.” Second, economic management in the private and public sector failed to anticipate risks and did not respond to them timely and adequately. A major problem in the private sector was allegedly remuneration on the basis of short-term performance because shareholders, or principals, did not have the same information as their agents, or managers, who took excessive risk in pursuit of short-term compensation in the form of cash bonuses instead of long-term holding of stock. Supervisors did not have the appropriate tools to respond to the crisis and did not use existing ones adequately. Policymakers have allegedly corrected the major problems of “engineering” and “management” by the Dodd-Frank financial regulation act and related regulatory measures: (1) Dodd-Frank has provided for oversight of the shadow banking system while private institutions have improved their management of risk and liquidity; (2) Dodd-Frank creates a Financial Stability Oversight Council to monitor systemic risk; and (3) many other measures strengthen capital and liquidity requirements, transparency and margins in trading derivatives and so on (Ibid).

There are two conclusion of this analysis: (1) economic policy was not a factor of the credit crisis; and (2) the Dodd-Frank act plus regulatory measures have addressed correctly all the causes of the crisis, providing a regulatory and supervisory framework to prevent future crises. These two issues are discussed in turn. First, monetary policy did actually encourage high risks, excessive leverage, low liquidity and unsound credit decisions. The problem may be the unfeasible statutory mission of the Fed: “the goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek to ‘promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates’”( http://www.federalreserve.gov/pf/pdf/pf_2.pdf 1). These conflicting unattainable goals continuously appear in the statements of the Federal Open Market Committee (FOMC) such as that of the last meeting before the congressional election of Nov 2 held on Sep 21: “The Committee will continue to monitor the economic outlook and financial development and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate” (http://www.federalreserve.gov/newsevents/press/monetary/20100921a.htm ). The FOMC lowered the fed funds target rate from 6.5 percent on May 16, 2000 to 1.75 percent on Dec 11, 2001 and then to 1.25 percent on Nov 6, 2002, culminating in 1 percent on Jun 25 2003 where it was held at that level until raised to 1.25 percent on Jun 30, 2004, reaching 5.25 percent on Jun 29, 2006 after 17 consecutive increments of 25 basis points per FOMC meeting (http://www.federalreserve.gov/monetarypolicy/openmarket.htm#2003 ). The lowering of the fed funds rate to 1 percent with forward guidance that it would be maintained at that level indefinitely, or until deflation fears subsided, encouraged the financing of everything with short-dated funds. There was a worldwide hunt for yields as risks were ignored because of huge amounts of cheap short-dated funds provided by the Fed, exemplified by a rise in the DJIA by 87.8 percent in 2002-7 and the increase in new house sale to the annual equivalent rate of 1283 thousand in 2005 falling to 375 thousand in 2009 (see Table 1 in the prior post of Sep 12, 2010 http://cmpassocregulationblog.blogspot.com/ ). The housing crisis was the result of the near-zero fed funds rate combined with the suspension of the auction of the 30-year Treasury, housing subsidy of $221 billion per year, general policy of providing housing at “affordable,” actually subsidized, prices and the purchase and guarantee of $1.6 trillion by Fannie and Freddie with leverage of 75:1 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). Second, the Dodd-Frank act is based on an incorrect diagnosis of the causes of the financial crisis, creating individual measures and a whole framework that is unpredictable and dependent on rules and studies by several regulators. The outcome is an inopportune reduction in the volume of credit, an increase in interest rates and further uncertainty when the economy requires financing for higher growth and employment creation.

II Quantitative Easing. On Sep 22, “Reserve Bank credit” in the Fed balance sheet stood at $2290 billion of which long-term securities held outright were $1984 billion, composed of $739 billion Treasury notes and bonds, $154 billion federal agency securities and $1091 billion mortgage-backed securities (MBS) (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The FOMC evaluated on its Sep 21 meeting that “inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate” and decided that “the Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings” (http://www.federalreserve.gov/newsevents/press/monetary/20100921a.htm ). The statement of the FOMC Aug 10 meeting sketched the policy and its rationale: “to help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm ). The core personal consumption expenditures (PCE) price index, excluding food and energy, rose 0.1 percent in Jul compared with an increase of less than 0.1 percent in Jun (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). This is well below the 1.5 to 2.0 percent annual inflation range that could be interpreted as above the risk of deflation. The seasonally adjusted annual rate of change of the price index of PCE in 2Q10 is 0.0 percent and -3.6 percent for durable goods (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=67&Freq=Qtr&FirstYear=2008&LastYear=2010 ). The elections for Congress are on Nov 2 when the FOMC meets for a two-day meeting ending with decisions on Nov 3 (http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm ). With unemployment high and inflation lower than desired, will the FOMC engage in further quantitative easing or QE2?

Yields of long-term financial assets can affect spending, saving and investment because they are the cost of corporate debt used for investment of long gestation. Substantial increases in the money supply by purchases of long-term securities would result in rebalancing of portfolios of investors, raising long-term yields that could stimulate investment (Ben Bernanke and Vince Reinhart, http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224-5 and see The Global Recession Risk, 95-107 on the experience of Japan). Other effects could occur through expectations that the Fed will maintain low rates for a long period or that the shift of the government debt to the Fed balance sheet reduces expectations of taxation. In the simple return to maturity expectations hypothesis, the yield to maturity of a long-term bond is the product of all the one period proportionate forward yields plus one (Jonathan Ingersoll, Theory of Financial Decision Making, Rowman, 1987, 389-90). The differences in expected returns of bonds of different maturities are explained by the liquidity preference and preferred-habitat theories by risk arguments (Ibid, 401-5). The “term premium” in Treasury securities consists of the extra return above short-term yields required by investors in holding a security with fixed yield and high duration (http://www.newyorkfed.org/research/staff_reports/sr441.pdf ). Duration is the interest sensitivity of prices to changes in yields, which is typically higher for long-term securities, such that an increase in yields can result in substantial losses in price or principal. Quantitative easing has withdrawn securities with long duration, which may have resulted in lower overall duration in securities held outside the Fed and thus lower duration risk or term premium by investors. An additional effect derives from the purchase of MBS that because of negative convexity experience higher magnitudes of declines in prices when interest rates increase than magnitudes of increases in prices when rates decline. The decline in relative yields of the securities purchased by the Fed may spread to other fixed-income securities and increase liquidity of broad segments of assets also with beneficial effects on investment (Ibid). Fed purchases were relatively substantial. The purchase by the Fed of $1.7 trillion in assets between Dec 2008 and Mar 2010 represented 22 percent of the outstanding $7.7 trillion of agency, MBS and Treasuries. In a different measurement, the Fed purchased $850 billion of 10-year equivalents in the three asset classes that represented more than 20 percent of $3.7 trillion outstanding. The conclusion of research by the Fed staff is that “the overall size of the reduction in the 10-year term premium appears to be somewhere between 30 and 100 basis points, with most estimates in the lower and middle thirds of this range” together with additional benefits resulting from the increase in liquidity of markets and reduction of private-portfolio holdings of riskier securities with embedded options in the form of prepayment risk of MBS (Ibid, 28).

III Financial Arbitrage of Monetary Policy. Chairman Bernanke has coined yet another phrase, the recovery without vigor: “Although financial markets are for the most part functioning normally now, a concerted policy effort has so far not produced an economic recovery of sufficient vigor to significantly reduce the high level of unemployment” (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm http://professional.wsj.com/article/SB10001424052748703499604575512242273196062.html?mod=wsjproe_hps_LEFTWhatsNews ).Vigor of economic growth and hiring could be restrained mainly by coercive structural changes to business models at the time when households, business and even the public sector struggle to recover from the credit crisis and global recession. Quantitative easing could fail in these circumstances no matter how successful in lowering yields because of growth-inhibiting structural changes. The minutes of the FOMC meeting on Aug 10 provides evidence on an important cause of weakness in investment, spending and hiring: “a number of participants reported that business contacts again indicated that uncertainty about future taxes, regulations, and health-care costs made them reluctant to expand their workforces” (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100810.pdf 7). Even if required monetary policy impulses had been accurately measured and GDP forecast precisely, the structural shock to the economy resulting from restructurings and regulation affecting business models would have prevented fast or “vigorous” recovery and full employment. The expectation of increases of taxes because of the upward tilt of government spending is frustrating investment, consumption and hiring.

An important fact is that the default rate of corporate debt in the US is expected by Moody’s to fall to 3 percent at the end of 2010, substantially lower than the peak of 14.6 percent in Nov 2009 and even lower than the rate of 3.1 percent in Aug 2008 (http://professional.wsj.com/article/SB10001424052748703399404575506222148668414.html?mod=wsjproe_hps_LEFTWhatsNews ). The year-to-date total return of the Barclays Capital Treasury index is 16.95 percent and of long-term corporate debt 12.99 percent (http://online.wsj.com/mdc/public/page/2_3022-bondbnchmrk.html?mod=topnav_2_3000 ). Prices of high-yield bonds rose to the highest levels since 2007, which are nearly twice higher than during the trough of the credit crisis and Dealogic, as reported by the Wall Street Journal, estimates that sales of high-yield bonds posted a record of $172 billion in the first nine months of 2010 (http://professional.wsj.com/article/SB10001424052748704416904575502181908674958.html?mod=wsjproe_hps_LEFTWhatsNews ). Investors appear to have avoided equities, concentrating positions in fixed-income securities, in a first phase of arbitrage of economic policy that restricted investment and hiring by the private sector with legislative restructurings, regulation and expectations of higher taxes. In the second phase after November there could be an exodus out of fixed income into equities that could be reinforced by the use of $2 to $3 trillion of corporate cash in excellent available opportunities in consolidation by the capital markets through mergers and acquisitions. Equities would rise sharply while bond prices could drop. The private sector could invest and hire again with a revival of economic activity. Quantitative easing could be arbitraged away with rapid increases in long-term yields resulting from shorting high duration and convexity.

The downward trend of stock indexes in the US since the second half of Apr appears to be reversing, as shown in Table 1. The Dow Jones Industrial Average (DJIA) gained 2.4 percent in the week of Sep 24; is significantly below the decline of 13.6 percent from recent peak to trough; and has gained cumulatively 6.9 percent in the past four weeks. The S&P 500 gained 2.1 percent in the week and 7.9 percent in the past four weeks. The NYSE Financial gained 2.6 percent in the week and 6.2 percent cumulatively in the past four weeks. There may still be a late-year rally in US equities when markets sense a pause in legislative restructurings and regulation, funds flow away from fixed income into equities and consolidation through mergers and acquisitions realizes attractive opportunities.

 

Table 1, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 9/24	Week 9/24
DJIA	4/26/10	7/2/10	-13.6	-3.0	2.4
S&P 500	4/23/10	7/2/10	-16.0	-5.6	2.1
NYSE Financial	4/15/10	7/2/10	-20.3	-10.9	0.7
Dow Global	4/15/10	7/2/10	-18.4	-6.4	2.6
Asia Pacific	4/15/10	7/2/10	-12.5	-1.5	1.1
Shanghai	4/15/10	7/2/10	-24.7	-18.1	-0.2
STOXX Europe	4/15/10	7/2/10	-15.3	-6.4	0.1
Dollar	11/15/10	6/25/10	22.3	12.1	-3.4
USB Comm.	1/6/10	7/2/10	-14.5	-3.3	2.0
10-Y Tr	4/5/10	4/6/10	3.986		2.607

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

 

IV Economic Indicators. Real estate and job markets are still weak with mixed results in sales and industry. After-tax profits of retailers with assets of $50 million or more, not seasonally adjusted, rose 0.9 percent in the second quarter of 2010 relative to the first quarter, reaching $16.1 billion, which is well above $13.1 billion in the second quarter of 2009. Nominal values have returned closer to the level of 2007 of $17.6 billion (http://www2.census.gov/econ/qfr/current/qfr_rt.pdf ). Inflation of producer prices between 2009 and 2010 has been 8.3 percent such that inflation-adjusted profits have declined. New orders for manufactured durable goods fell 1.3 percent in Aug, after declines in three of the past four months, but rose by 2.0 percent excluding transportation and by 1.2 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). Building permits were at the seasonally-adjusted annual rate of 569,000 in Aug, 1.8 percent above 559,000 in Jul but 6.7 percent below 610,000 in Aug 2009. Housing starts were at the seasonally-adjusted annual rate of 598,000 in Aug, which was higher by 10.5 percent relative Jul and 2.2 percent above 585,000 in Aug 2009 (http://www.census.gov/const/newresconst_200608.pdf ). Housing starts in the first eight months of 2005 were at 1471 thousand not seasonally adjusted (http://www.census.gov/const/newresconst_200608.pdf ) compared with 417 thousand in the first eight months of 2010 for a decline of 71.6 percent. Single-family sales of new houses were at a seasonally adjusted annual rate of 288,000 in Aug 2010, unchanged from Jul but 28.9 percent lower than 405,000 in Aug 2009. The median sales price of new houses in Aug was $204,700 and the supply of unsold houses was equivalent to 8.6 months at the current sales rate (http://www.census.gov/const/newressales.pdf ). Sales of new houses in the first eight months of 2010 were at the seasonally unadjusted annual rate of 234,000, which was lower by 74.1 percent than 906,000 in the first eight months of 2005 (http://www.census.gov/const/newressales_200608.pdf ). The National Association of Realtors estimates that existing home sales rose by 7.6 percent in Aug but are still down by 19.0 percent relative to Aug 2009 (http://www.realtor.org/press_room/news_releases/2010/09/ehs_move ). The house price index of the Federal Housing Finance Agency fell 0.5 percent from Jun to Jul and 3.3 percent in the 12 months ending in Jul. The index has declined by 13.8 percent since its peak in Apr 2007 (http://www.fhfa.gov/webfiles/16978/MonthlyHPI92210F.pdf ). Initial jobless claims seasonally adjusted in the week of Sep 18 rose by 12,000 to 465,000, which is still a relatively high level (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).

V Interest Rates. The 10-year Treasury fell to 2.61 percent from 2.74 percent a week earlier but is higher than 2.55 percent a month ago. The 10-year government bond of Germany traded at 2.35 percent for a negative spread relative to the comparable Treasury of 26 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1285461652138 ). The Treasury maturing on 08/20 with coupon of 2.63 percent traded at 100.13 on Sep 24 (http://markets.ft.com/markets/bonds.asp?ftauth=1285461652138 ). The price of the Treasury with 2.63 percent coupon maturing on 08/2020 would settle on Sep 27 at 88.98077 if the yield were to back up to the recent peak of 3.986 percent attained on Apr 2, for a loss of 11.1 percent. There is an ignored duration trap in quantitative easing. If funds stampede out of fixed income into equities, there could be major losses in portfolios long in duration resulting from fire sales. During the credit crisis, fire sales in a segment of fixed income, such as MBS, spread to other segments because of capital losses and increasing margins and haircuts that forced fire sales across asset classes (Markus Brunnermeier and Lasse Pedersen, Review of Financial Studies 22 (6, 2009) cited in Pelaez and Pelaez, Regulation of Banks and Finance, 223). The overall duration and convexity outstanding may be irrelevant because fire sales in typically concentrated portfolios may spread through all segments of fixed income.

VI Conclusion. If there is a pause in legislative restructurings and regulation, funds could flow away from investment in fixed income to equities, causing a late-year rally in US stock indexes. The rise in long-term yields in an improved economic environment with rising equities could make further quantitative easing unnecessary and likely harmful. Chairman Bernanke contributes yet another critical insight about economics: “Almost universally, economists failed to predict the nature, timing, or severity of the crisis; and those few who issued early warnings generally identified only isolated weakness in the system, not anything approaching the full set of complex linkages and mechanisms that amplified the initial shocks and ultimately resulted in a devastating global crisis and recession” (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm ) The FOMC is headed and supported by economists who master and contribute to the state of the art. This most important committee should ponder if it is possible to anticipate and simulate the consequences of another trillion dollars of quantitative easing that could bring its holdings close to 30 percent of 10-year equivalents in the target asset class. The Fed may simply distort again the risk spreads among asset classes of the same duration and the term risk spread within the same class with the same unpredictable consequences that plague economics on the pricing of risk that is critical in risk/return calculations and decisions not only in the financial sector but in the general economy. An important unpredictable consequence is what happens by increasing quantitative easing to more than 30 percent of 10-year equivalents of major classes of securities while structural restructuring by legislation and regulation withhold the vigor from the normal V-shaped recovery of recent strong contractions. Vigorous quantitative easing may contribute to restrict the vigor of economic recovery required for creating actual and not counterfactual or “saved” jobs (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

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