Stupid headline of the day

"Dollar Soars as China Surprises Markets with Reserve Requirement Hike" (source not disclosed out of kindness).

The dollar may be "soaring" (by a full 0.81% !) today, and China may have hiked rates, but the two events are in no way related. You see, when a country has a fixed exchange rate, it has no control over monetary policy: reserve requirement hikes will induce more hot money inflows (looking for a higher return then dollar-denominated money funds, with no currency risk vs. the dollar), which means a higher money supply - since the central bank has to print the yuan needed to be sold to foreigners in exchange for foreign currency so as to keep the exchange rate constant. China has tried to sidestep this with controls on capital flows but everyone knows they are looser than the US-Mexico border. This is econ 101 and is known as the impossible trinity.

What is the relation between this and my saying the above headline is stupid? Because if China is hiking rates, it shows at least an intent, a signal if you will, of tightening monetary policy. But as I just discussed, this can only happen if China lets its exchange rate appreciate.

And that would be everything but positive for the US dollar.

The long-term costs of bailouts and nationalization of mortgage debt on inflation and external debt

After years of reading his weekly commentary, I have finally managed to detect a small mistake (actually two) in John Hussman's otherwise implacable logic. Let's see that paragraph, which is about the consequences of the current and future enormous issuance of Treasury debt:

It may not appear to be costly at present, since risk-averse individuals conscious of credit risks, and foreign countries running massive trade surpluses, are still willing to accumulate the Treasury securities being issued, with no apparent impact. But ultimately, those securities will either stand as claims on our future national production, or they will be inflated away. Either the Treasury securities will retain value, so that holders such as China get to use them to acquire our productive assets in the future, while we ultimately tax ourselves in order to pay off that debt, or we must dilute the ability of those Treasuries to claim real goods and services, which is another way of saying we inflate away the debt.

There are two mistakes here, a tiny one and a more important one. First, it is wrong to say that foreigners will in the future acquire more U.S. productive assets: they already, today, by buying these newly issued securities, receive a higher share of U.S. national income through interest. Interest comes from taxes, which are paid thanks to productive assets. In other words, whether foreigners swap their Treasuries for U.S. equities or stick with their Treasuries, they still claim larger share of U.S. assets.

The second, bigger mistake is to believe that the U.S. can choose to swap an international redistribution of wealth problem (the 'either' part of Hussman's argument) for a national redistribution of wealth through inflation. There is no free lunch. 'Inflating away' the national debt is not a good expression as the debt doesn't really go 'away': it is just swapped for other securities, while the same amount is owed to foreigners.

To be specific, inflation will not resolve anything because it will result in a deterioration in the trade balance (higher pricing power to foreign producers), which itself will result in a deterioration in next external assets (claims on foreign assets minus domestic assets owned by foreigners). When all is said and done, the U.S. NIIP (Net international investment position) would have been the same with or without inflating the debt away, or maybe even worse due to the fact that some foreign producers are better positioned for a high inflation environment (think commodity exporters), and because a collapsing dollar will allow foreign investors to buy U.S. assets on the cheap.

Inflation does redistribute wealth from savers to borrowers inside a country. It does not allow a nation to escape from transferring its wealth abroad. There is only one way to do that: default.

Hamilton on the Term Deposit Facility

Excerpts (full post here):

We sometimes describe fiscal policy as determining the overall level of the public debt, while monetary policy determines the composition of that debt between money and interest-bearing federal obligations. By that definition, the Fed has clearly now entered the realm of implementing fiscal policy, by issuing debt directly in the form of interest-bearing reserves, reverse repos, and now term deposits.
The Fed would no doubt argue that it is doing so wisely, and that the decision to absorb Fannie and Freddie's debt and mortgage guarantees into the fiscal liabilities of the U.S. government has already been made by Congress and the President. The Fed is simply taking that reality as given and trying to minimize collateral damage.
Or one might see it this way: political pressures had been the cause of the quasi-nationalization and then de facto nationalization of mortgage debt in the first place, and the Fed found itself inextricably drawn into the mess. There is now political pressure to inflate the debt away, from which pressure the Fed nevertheless sees itself as immune.

Paul Kasriel: Airplane thoughts

http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0912/document/ec121009.pdf

Econbrowser: Commodity prices and the Fed

http://www.econbrowser.com/archives/2009/12/commodity_price_2.html

CR: Effect of Fed buying MBS

From Calculated Risk Blog:

It isn't that Fannie and Freddie "can’t sell to an end buyer", it is that the GSEs [securities] will be selling for a lower price (higher yield) when the Fed completes the MBS purchase program. At that time mortgage rates will probably rise by about 35 bps to 50 bps (relative to the Ten Year) in order to attract other buyers. Alone that isn't all that "scary".

The Fed has issued more than a trillion Federal Reserve Notes (otherwise known as dollars) to buy mortgage backed securities. This is is serious currency debasement for 50 bps! However, I believe the total impact has been bigger: for one, it probably has driven Treasury yields lower than otherwise, so even though the effect on the spread is only 50 bps, the effect on the yield must have been bigger. Second, it has increased liquidity in this market and increased confidence (perception) towards the ability of the GSEs to retain their role in the financial system.

But combined with the growing problems at the FHA, the distortions in the housing market caused by the first-time home buyer tax credit, rising delinquencies, the uncertainty of the modification programs, and likely further house price declines in many bubble states - there are serious problems ahead for the housing market.

Click here for the full post.

Bloomberg links: Fed Watch

Fed Faces Biggest Blow to Authority, Independence in Dodd Banking Measure The Federal Reserve faces the biggest blows to its authority and independence in five decades under legislation championed by its lead overseer in the U.S. Senate.

Fed Officials Say Recovery Will Be Slow as Unemployment Hampers Spending The U.S. economy will be slow to recover from the deepest recession since the 1930s as rising unemployment curbs consumer spending, Federal Reserve officials said.

Fed's Lockhart Says Banks' Commercial Real Estate Losses to Slow Recovery Federal Reserve Bank of Atlanta President Dennis Lockhart said the economy will probably recover slowly from the deepest recession since the 1930s because of rising bank losses, especially in commercial real estate.

Gold is overbought

I have been an advocate of gold as an investment for many years. I allocated the greatest part of my savings to gold in 2003 when it traded below $350 an ounce, and I can't say I regret that decision. I believe gold is still in a bull market, however now may not be a fantastic entry point:

• The Fed is not going to stay on hold forever. Although we are many months away from removing accomodation, Fed officials have already started to discuss exit options. Moreover, Fed balance sheet expansion is probably over (at least for now, until and if we get a second economic leg down). Fedspeak might also become increasingly hawkish as the dollar falls and bubbles develop everywhere (see previous posts). So we may see a short term sell off if and when that happens.
  
• Inflation is not an immediate problem. Fiscal deficits by themselves don't cause inflation, money does. Inflation might become a problem eventually as the money supply has increased quite a lot last year, but since the rate of growth in the money supply has slowed of late, one could still imagine that the money supply will be reined in before inflation pressures develop. I personally don't think that will happen, but that possibility can at some point be priced in by the market, which will not be gold-friendly. Finally, I believe we will see slower than expected growth next year, which will put a damp on inflation expectations (at least for a little while longer).
• Gold is overbought. Just look at any chart: it's overbought by any measure on daily charts and weekly charts. Plus it has closed up almost every week in the past several months, which means it has become a one-sided bet.

Since gold tends to go up in spikes, it might go up another 10% or 20% before it corrects. However, when that happens, it is likely that it will go down back to the current levels, maybe even lower. I already own gold and I'm in for the long-term, so I'm not selling (I'm not trading gold, I'm just sitting with it until I believe the bull is over). However, I wouldn't advise anyone to buy a significant amount of gold right now, and short sellers should be on the lookout for a potential short candidate in the near future.

Updates:
Charts
Hulbert Sentiment Index

Buiter on bubbles and China

Willem Buiter is a very smart and knowledgeable person; however his blog posts are always very (very!) long. No worries dear reader, I am here to select the good stuff for you (from: Beware asset market & credit booms bubbles & busts in emerging markets). I will also highlight a classic rookie mistake he made, much like I did in my previous post.

(...) the world is being flooded with official liquidity by the leading central banks of the overdeveloped world.

First remark: the expression "overdeveloped world" may be the best thing I've heard since "Goldilocks economy". It just explains so much in one single world... this is economic poetry! I don't know if Buiter originated it, it is the first time I see it. It continues:

Commercial banks either hoard the newly injected central bank liquidity at the central bank in the form of deposits or use it to purchase safe liquid assets, such as the sovereign debt instruments of reasonably solvent nation states. (...) Broad monetary aggregates are growing little if at all in the overdeveloped world and credit growth to the non-financial enterprise sector and to the household sector remains minuscule.  We are therefore unlikely to see a credit boom or asset market frenzy any time soon in the advanced industrial countries, let alone any pick-up in domestically generated inflation for indices like the CPI. The massive injection of official liquidity by the Fed, the ECB, the Bank of England, the Bank of Japan and other central banks in the north-Atlantic region is much more likely to show up as credit and asset market booms, bubbles and - eventually - busts in those emerging markets that are growing rapidly again, that is, most emerging markets other than those in Central and Eastern Europe.  China, Brazil, India, Indonesia, Singapore, Turkey and Peru are but some of the countries at risk. (...) The reason for this liquidity spill-over is the desire of many of the rapidly expanding emerging markets to prevent a large real appreciation of their currencies vis-à-vis those of the cyclically lagging advanced industrial countries. (...) The accumulation of foreign exchange reserves that results is only partly sterilised. The result is externally financed expansion of the domestic money supply and more rapid domestic credit growth. This will leak at least partly into domestic asset markets, creating the conditions for boom, bubble and bust.

And now, on China:

China is especially at risk of booms and bubbles in its stock market, its residential housing market and its commercial and industrial property markets.  That is because the externally funded liquidity injection resulting from Chinese attempts to keep down the external value of the yuan are reinforced by further domestic credit expansion associated with the Chinese fiscal stimulus. (...) China is creating massive excess capacity in export-oriented industries (and indeed in some of the low-tech consumer goods where it no longer is the global low-cost producer).

(My emphasis). Continues:

In two or three years, when these loans will be going into default on a large scale, the central bank or the ministry of finance will recapitalise the banks, using a mixture of government debt, central bank domestic credit and foreign exchange reserves.

And there it is - the rookie mistake: recapitalising the Chinese banks with foreign exchange reserves. I've seen that countless times but I didn't expect Buiter to fall into that trap. Let me explain: you cannot use foreign exchange currency (in that case, mostly dollars) to recapitalise a domestic currency (yuan) balance sheet. Have you ever heard of a company having equity in foreign exchange currency ? It is just silly ! Now, what you could in theory do is convert this dollars in yuan, and use the proceeds to recapitalise the banks. But that would entail a large appreciation of the Chinese currency: remember, if the central bank just stopped buying dollars, the renmibi would most likely increase by 20% to 40% rappidly. What would happen then if the central bank started to sell dollars ? A very destabilizing overshoot in the exchange rate. Now, would you like to see that happen to your country, if at the same time your country's banking system is in need of being recapitalized ?

Let's continue with Buiter, who is otherwise right to the point:

The boost to domestic demand is overwhelmingly in the form of fixed investment, much of in the the wrong, old industries.  Without a miraculous recovery of export demand growth, excess capacity will re-emerge with a vengeance in the export industries.

(...) Other emerging markets too are likely to be faced with domestic asset market booms and bubbles, in particular the oil and gas exporting nations of the Gulf Cooperation Council (GCC).  These countries still peg to or shadow the US dollar quite closely, despite a number of attempts, through basket-pegging and similar manoeuvres, to loosen their ties to the US dollar. (...) The credit and asset market boom, bubble and bust I foresee for the rapidly growing emerging markets is not inevitable.  It is a policy choice.  If the emerging market countries in question are willing to let their currencies appreciate sufficiently against the US dollar and the currencies of the rest of the overdeveloped world, there will be no domestic monetary and credit expansion financed by imperfectly sterilized foreign reserve inflows. For China, preventing excessive credit growth and asset booms and bubbles is more difficult, as in addition to the external liquidity injection, the government is, through the banking system, injecting massive amounts of domestic liquidity into the economy.  This would become unnecessary if China were able to switch the composition of production and of domestic demand towards consumer goods and services and non-traded goods and services.

2010 outlook

I briefly mentionned PIMCO's New Normal, which is the company's secular outlook, in my last stock market comment (PIMCO is one of the largest bond management companies). Here are some some excerpts from their latest cyclical outlook. I will then criticize one of their points, well, because it's by bettering the master that one becomes a master... (already attempted here and here).

Here is their cyclical outlook:

Consider the notion of an “escape velocity” for the economy – a forward movement that is significant enough for a sustained economic expansion to set in. There are three contributors. The first is the unprecedented amount of global fiscal and monetary stimulus. This is now in play in a big way. The second is the inventory rebuilding cycle, which is starting to take hold. While these two factors are necessary for reaching escape velocity – and are very much in play, contributing to seemingly robust growth numbers for the third and fourth quarters – they are not sufficient. We also need sustainable private sector demand.
In PIMCO’s Investment Committee deliberations, Bill came up with an analogy of a rocket, which has fired two boosters but needs to fire a third in order to escape the earth’s gravitational force. That third booster, which is the final component necessary to achieve escape velocity, has to come from a source of private demand: either consumption, investment or exports.
When we look at the extent to which the major economies, especially the U.S., are challenged by their balance sheets right now, we are not yet expecting that the third booster is going to fire. As a result, we question the expectations in the marketplace for a V-shaped recovery.

I am holding back on using my model to compute 2010 GDP forecasts until next week (I am waiting for the Q3 GDP release), but for now it does paint a similar picture: relatively "strong" growth (around 2-2.5%) in the next few quarters, followed by a drop later in 2010. But more on that next week. What I want to talk about now is the following, from the same PIMCO piece:

The extraordinarily low fed funds rate has pushed money out of low-risk and “risk-free” assets into higher risk assets, which has led to the bounce in asset prices.

This is a classic rookie mistake which has me thinking that maybe Gross and El-Erian (the PIMCO heads) didn't write that piece themselves, but rather had an intern do it for them (I should have his job). You see, there is no such thing has money flowing out or into anything. Consider this: one day, the whole earth population wakes up and decides to buy (flow into) equities. Well if the transaction is to take place, someone has to sell equities to them, and will thus necessarily flow out of equities. And this, by the exact same amount of money. Another way to say this is that supply equals demand, always. To go further, imagine that all this money that the buyers spent on equities was previously in money market funds. When they sold these money market funds, someone had be there to buy them: in the end, no net amount of money whatsoever has left the money markets. What can change though, is the price at which buyers and sellers can agree to make the transaction, which depends on their respective eagerness to hold (or not hold) equities.

Contradicting McCulley

It is not a great day for me as I am writing this post which is a rebutal to Paul McCulley, one of the persons from whom I have learned the most. He tends to be too keynesian sometimes, and his last month's commentary is one example:

To be sure, we are presently living in an unusual world, in that the Fed is pegging the Fed funds rate at effectively zero. But it is not stimulating robust demand for credit, or alternatively, it is not stimulating bankers to gin up demand for credit by loosening terms and conditions to prospective borrowers. Actually, reality is probably a bit of both: reluctant borrowers and reluctant lenders.

In my opinion this is completely wrong. The Fed's policies have indeed stimulated robust supply of (risk-free) credit from the bankers and robust demand for credit by the Treasury. I don't have a chart at hand showing of how much of the Treasury's recent borrowing has been financed by the U.S. financial system, but I trust that it's the bulk of it.

Thus, we can categorically say that the near-zero Fed funds rate is not, for the moment, fueling an inflationary pace of aggregate demand growth relative to the economy’s supply potential. And neither is the Fed’s Credit Easing, which is the proximate cause for the explosion of excess reserves in the system. Yes, in the fullness of time, zero Fed funds could conceptually re-ignite borrowers’ and lenders’ mojo. Indeed, that’s precisely the Fed’s objective. And if and when that objective is achieved, the Fed funds rate will need to be hiked to temper the re-ignited mojo, so as to prevent the economy from overheating.

This part is way too keynesian even for McCulley. Kasriel finds a correlation of 0.64 between M2 and inflation, and only 0.08 (!) between the output gap and inflation. Also, look at how inflation flamed up in 1934 while the unemployment rate was in the high teens.

Kasriel: The Great Depression – Just the Facts, Ma’am

As always the great Paul Kasriel has very interesting insights (emphasis is mine):

(...) the hurdles that today’s economy has to jump over to enter a recovery would appear to be much lower than the hurdles that were erected between 1930 and 1932.
In addition, the federal government is about to embark on a massive fiscal stimulus program. Will the Fed monetize much of the new debt issued to fund this program? We do not know yet. But if recent history is any guide, the answer is yes. Chart 7 shows that the growth in bank reserves in 2008 was almost 149% – an unprecedented increase. If the federal government embarks on a large spending spree and the Fed “prints” the money to fund the spending, then the pace of real economic activity is bound to increase. How long it will take for higher prices to begin to erode real activity is another question. But never underestimate the initial positive impact on aggregate demand of that powerful combination of increased federal government spending/tax cuts and a central bank running the monetary printing press at a high speed.

The economic data are likely to be abysmal through the first half of this year. The popular media will reinforce the gloom of the data. The same pundits who did not see this downturn coming will not see the recovery coming either. My advice to you is to keep your eye on the index of Leading Economic Indicators. If history is any guide, the LEI will signal a recovery well ahead of the pundits.

I plan on developing an enhanced version of the LEI for my Master's dissertation for a reason.