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Grab your tinfoil hat. Today you’re going to need it.
You won’t need it right away, but I’ll let you know when you will.
Update from the Fed
Last week we got another update from the Federal Reserve as they released the minutes of their latest meeting. For the most part, it was more of the same. But they did make one interesting change to their language. They extended their pledge to keep interest rates “exceptionally low” from mid-2013 until 2014. That’s a long time.
Rick Santelli’s immediate reaction on CNBC was, “welcome to Japan!” Which is true in one sense — the sense that bonds are apparently going to plateau, Japan-style, rather than begin a new secular bear market. A couple weeks ago I heard Gary Shilling call for a 2.5% yield on the 30-year bond, and, heck, I can see that happening now.
But the U.S. is not like Japan in some major, fundamental ways. The first is demographics. Japan’s are nightmarish. Ours are pretty good. Japan has an old, shrinking population, with a low birth rate and zero immigration rate. The U.S. population is young by comparison, even with all the Boomers. Our net birth rate is still positive, and after immigration, the U.S. adds a meaningful number of new people to its population every year.
Nobody really talks about it, but demographics are the easiest, surest, most effective way to sustainably grow your economy. Over the long run, I’m not sure there is a single more powerful factor than demographics to the performance of an economy, and by extension, its stock market. If I was King for Life of the United States, I’d make sure that my population kept growing by a few percent every year.
So the comparison between the Bank of Japan and the Fed only works up until a certain point. Anyway, I had three thoughts about the Fed’s latest verbiage on interest rate policy.
Reading between the lines of the Fed minutes
The first thing that stands out is that the Fed must see extremely low inflation for the next several years. Not only that, but they must be of the opinion that the inflationary risks are completely non-existent. The battle is clearly still one against deflation, one where the Fed would like to see more inflation. And for reasons that I’ll get to in a minute, I am done betting against these fellas.
The second thought I had is that the Fed must still be very concerned about the health of the economy. This can be conceptualized as “upside risk” in the economy i.e. the risk that the economy rockets higher for a few quarters. The Fed’s prognostications must contain essentially zero upside risk in the economy. I know that this year the market is off to a very enthusiastic start, but don’t expect to see 4% GDP growth in any quarter any time soon. In fact, the latest data seems to suggest that my biggest economic concern, that spenders would go back into their shells and save for a while, seems to be materializing.
The third point is that the Fed has really painted themselves into a corner here. How will markets react if they do have to change their rate policy or at the very least, change their language? All of their cards are on the table and if they produce a magic ace from up their sleeve or change the rules in the middle of the game, the market will accuse them of cheating and probably get very angry. In fact, this was the very essence of Charles Plosser’s objection. Not all of these Fed governors feel the same way about policy, you know.
Anyway, it’s clear that The Fed remains committed to punishing savers through financial repression, and they have by no means given up their attempt to stimulate the economy by inflating the stock market. It looks like this negative real rate environment is going to be with us for a while, and in the meantime, investors will have to buy something. That “something,” in case you’re wondering, is the stock market.
I’ve been writing about that for what seems like forever now. On any given week, the normal, natural direction for the market is up. And it will drift higher until something spooks investors and sends them into “risk off” mode. This is the modern psychology of investing. It’s a game of musical chairs. Everybody is forced to dance and dance until the music stops. Hopefully you can find a chair when it does.
Incidentally, with the S&P approaching old highs and the VIX down at 18.5, now is the time to start thinking about your risk management strategies. Times like this are when you shop for insurance and figure out where your closest emergency exit is in case the building catches fire.
OK, put on your tinfoil hat
There’s a peculiar, possible conspiracy theory here too. You guys all remember “Operation Twist” from last year, right? That was the QE2.5 program that a lot of investors weren’t sure what to make of. In Operation Twist, the Fed sold a bunch of very short-term bonds and bought bonds in the middle of the curve.
Last week, after the Fed pushed their “low rate” pledge out through 2014, guess what rallied the most?
Yeah. Bonds in the middle of the curve.
It almost makes you wonder how much of this had been thought out when they embarked on QE2 in the first place. With QE2, they bought a whole bunch of very short term government bonds. The next thing they did after that was announce to the world that they were going to keep rates low for an extended period of time. So naturally, bonds at the front of the curved rallied. In fact they rallied as far as they could go, with every bond shorter than 2 years carrying an interest rate of close to zero.
Once they had squeeze all the juice they could from very short-term bonds they were left with a portfolio with zero return and a bit of risk (if rates rose for some reason). I don’t like investments that carry risk and have zero return either. So the Fed started dumping those and buying bonds further out the curve.
I don’t have the expertise to say for sure, but my gut tells me that the Fed has profited rather nicely from its actions in the bond market. Not that that should surprise you. The Fed, like any good fund manager, has simply been talking their book. The only difference is that when the Fed talks their book, it has a major effect on the rest of the world.
Maybe this how they plan to offset some of the losses they’ll eventually have to eat from the very first quantitative easing, which was where the went out and gobbled up a bunch of mortgage-backed securities. That was the first action that really pissed off people like Ron Paul. Everybody knew a big chunk of those MBSes were junky and everybody assumed that those losses would eventually fall to taxpayers.
But maybe the Fed strategy since QE1 has been to make money so that they can offset the eventual losses on its mortgage backed security portfolio? That’s what all the good portfolio managers that I know do.
It’s certainly an interesting idea. I haven’t heard anybody else write about this. I have no idea if the theory is legit. The timeline is strangely convenient, but it could all just be coincidence.
Step 1: Buy stuff at the front of the curve.
Step 2: Make it rally.
Step 3: Once all the juice is dried up, swap it for stuff in the middle of the curve.
Step 4: Make that rally.
Not a bad strategy.
You might be wondering what’s next. Well, if I’m the Fed, and I have my own interests at heart, here’s what I’d do.
As of last week, the Fed held roughly $2.6 trillion of bonds. Of that, $850 billion are in long-term (10yr+) mortgage backed securities. There is a small chunk of long-term treasuries, but half of the Fed’s holdings right now are in 1-10yr Treasuries.
Now, given a balance sheet of long-term mortgage securities and middle-of-the-curve Treasuries, what would you do assuming your policy actions had a direct impact on the performance of your personal investments? Several things.
The first thing is that you do everything you can to help out housing. You don’t do it because it makes for good politics or helps out working class Americans on Main Street. No. You do it because if you don’t, you’ll take a bath on your personal investments. So you make sure that it stabilizes and recovers in the long-run. It doesn’t have to do it this year or even in the next five. You just have to make sure that a decade from now, housing is cruising along again at a healthy rate. Real estate may not be an exciting investment for the next year, but I think it’s a fantastic investment for the next twenty.
The next thing you do is you keep those short rates low and pocket the gains as your medium maturity bonds “roll down” the curve. After last week’s announcement, there isn’t much juice left to squeeze out of anything shorter than 3 years. But there is a little bit, and more between 3 and 7 years.
Personally, I expect the 10-year note to remain fairly stable, but I’d also expect that the 10-year has much more flexibility to move around. If rates on the 10-year bond rise to 3 or even 4%, the Fed’s balance sheet wouldn’t suffer much damage, if any at all. If you’re the Fed, it’s the stuff between 3 and 7 years that you want to protect. That’s where your biggest potential for loss exists.
As a result, I wouldn’t expect any dramatic change in interest rate policy until at least 2017. I wouldn’t expect short-term rates to be any higher than a percent or so when 2017 finally arrives. The reason why I don’t expect that is because the Fed will get spanked on its bond portfolio if it does. And since they’re the one calling the shots, I don’t see them doing anything like that. They’re not in the business of sabotaging their own investment portfolio.
(Or I guess I should say that hopefully they don’t want to hurt their own investments. Moral hazard exists at the Fed, too. Ultimately, taxpayers are the ones who will foot the bill if the Fed is wrong.)
One Way Out
You can see what I meant when I said that the Fed has really painted themselves into a corner. In fact, they haven’t just painted themselves into a corner until 2014. They’ve done it for at least the next five years, and possibly the next seven. When you decompose their balance sheet, it’s easy to see where their risk lies.
The Fed takes a lot of heat, particularly, though not exclusively, from the ultra-conservative right. I think there exists the perception in some circles that Bernanke and his brethren are these clueless yo-yos who are enacting reckless policies without thinking. Say what you want about the Fed’s actions. Who knows if this’ll all play out. In the meantime, let’s all agree that the guys pulling the strings are some clever sons of bitches. And I say that with the utmost respect. They have thus far played their cards brilliantly, in a manner that only the house can.
The problem is that you and I are the players on the other side of the table. I’m sure you’re really happy for the Fed that so far things have worked out splendidly for them and their balance sheet. But it has come at the detriment of savers. There is no other way to say it: every single thing the Fed has done since the crisis has punished savers. It has created a massive incentive to consume and take risk.
And I get it. I really do. I’ve been saying for ages that the risks to the economy and to inflation are all to the downside, and will remain so for many years to come. You battle that with counter-cyclical policies. When the natural desire in a post-crisis economy is to save, save, save, the policy objective should be one that encourages people to spend and invest. I just think the whole thing would sit better with me if the policy before the crisis was counter-cylical in nature as well. During the days of the tech bubble and the housing boom, we should have enacted national policy that encouraged saving rather than keep serving all the party-goers that wonderful, low-rate punch.
It’s hard, though. That requires a lot of discipline. Everybody applauded Alan Greenspan for everything he did up until the bubble burst. He was the gregarious frat party bartender who kept the keg flowing and the party rocking into the wee hours of the night.
Once we’ve recovered from our current hangover, and the economy is rocking in another secular growth party, will we have the fortitude to do what’s right? Will we be able to say “no” to that third or fourth drink when we know that two is our responsible limit? And will we be able to blame ourselves if we wake up with yet another hangover?
A Fine Framework for First-time Fedwatchers
The Fed has two official mandates: full employment and price stability. Remember that for your next cocktail party when you’re talking to some guy about money-printing or crazy low interest rates. (Also, why full employment is a legal responsibility of the Federal Reserve has always made me wonder, but this isn’t the place for that discussion. Maybe you can debate that at your next cocktail party.)
Every Fed action should always be interpreted in either one of those contexts. Everything the Fed does should either help create jobs or keep prices stable. Sometimes the relationship between the dual mandate and their actual actions seems tenuous or indirect. But it’s there. The Fed doesn’t act willy nilly.
While the Fed’s activity should always be assessed in the dual mandate framework, I think that interpreting their actions as though they were a portfolio manager or a gigantic hedge fund can provide some color. What they say and do can take on a slightly different meaning.
Ultimately, isn’t that one of the classic assertions of capitalism and economics? That all individuals ultimately act in their own self-interest? Why shouldn’t the Fed act in its self-interest?
This reminds me of an old Bill Gross strategy from around 2009. At the time, I remember him writing about how investors should “shake hands with the government” and basically do what Uncle Sam and Captain Ben do. Any investor who’s stuck to that strategy since 2009 has probably done quite well.
We all know what cards the Fed is holding. We all know what they’re going to do, and what’s more, we know why they’re going to do it. Rates are going to stay very low for a very long time. If you think the yield curve can’t get flatter, think again. If you think the economy is at the beginning of a major secular growth boom, think again. If you think that out-of-control inflation is a high probability event, think again.
The True Cost of the Fed’s Actions
In fact, on the subject of inflation, just because there won’t be a lot of it doesn’t mean that it won’t be a problem. Inflation is going to be a huge problem for people in the next five years, but it’ll manifest in a sneaky way. Negative real interest rates are here to stay.
The Fed’s latest moves have exacerbated this, pushing real interest rates down to around -1.5% as far out as 2017. Those moves may have been nice for the Fed’s personal investments and they may have helped stave off major economic decay, but they have absolutely eviscerated savers. This is the most difficult era in most of our lifetimes during which to be a saver.
Anyway, as a contrarian who’s a fan of counter-cyclical strategies and counter-cyclical behavior, part of me is wondering whether I’m dispensing the wrong advice.
Perhaps, in this era of deleveraging, it’s time to start borrowing aggressively if you haven’t already. If you’re a saver and weren’t over-leveraged when the systemic de-leveraging set in, you’ve probably still got cash. Last year I bought a house and my mortgage is 3.7%. The rate on my investment property just dropped to 3.1%. Adjusted for inflation, the money I borrowed is almost free. To a bank, my wife and I are a very low credit risk. But I’m not sure I’m worth 1% real. I certainly wouldn’t loan money to me at a real rate of 1%, and I’m not sure why a bank would either. They probably never would have if they couldn’t get Fannie Mae to back it.
Anyway, it’s food for thought. This is an abnormal and historic environment.
The Fed is punishing savers through financial repression. They’re not going to let up any time soon.
It’s hard to tell people to borrow money and take risk. I’m a prudent and hyper-cautious guy.
But, gosh darnit, I have to concede this battle to the Fed. That strategy has worked out pretty well so far. I just hope it doesn’t like some Japanese disaster movie.
- There’s a possible conspiracy theory out there that no one is talking about. All of the Fed’s language and policy maneuvers have explicitly benefited the positions they own directly on their balance sheet.
- Extending their language about this period of “exceptionally low interest rates” is just the latest example. I’d go one step further and assume that rates will be very low all the way through 2017.
- But more importantly, the Fed’s latest statements continue to underscore three things: 1) risk of inflation is low, 2) risks to the economy are high, and 3) they have painted themselves into a corner.