Increase in the Fed’s balance sheet – let’s be objective

Tuesday, July 7th, 2009

This post is a guest contribution by Paul Kasriel* of The Northern Trust Company.

In recent weeks two prominent economic commentators - Arthur Laffer and Alan Greenspan - have warned about the inflationary potential emanating from the unprecedented increase in the Fed’s balance sheet. Yes, as shown in Chart 1, reserves created by the Fed have increased by a staggering $858 billion in the 12 months ended May. But excess reserves on the books of depository institutions have increased by almost as much, $842 billion (see Chart 2). So, in the 12 months ended May, 98% of the increase in reserves created by the Fed has simply ended up as idle reserves on the books of depository institutions.

Yes, the bulk of the reserves the Fed has created are sitting idly on the books of depository institutions for now, but what if these institutions begin to lend them out in the future? Will this not result in an explosion of bank credit and the money supply, the raw ingredients of accelerating inflation - some might say the very definition of accelerating inflation? Why, yes, if the Fed were stand idly by.

If, however, the Fed wished to “neutralize” these excess reserves, it has the means to do so. The Fed now pays interest on reserves. If it observed an undesired “activation” of these hundreds of billions of dollars of excess reserves, it could hike the interest rate paid on excess reserves. Why would depository institutions lend more at the same loan rate when the risk-free rate they could earn from the Fed on excess reserves had risen?

They would not. So, the increase in the rate paid by the Fed on excess reserves would induce depository institutions to hike the interest rates charged on loans. All else the same, the quantity of credit demanded by the public would decrease and, therefore, bank credit and the money supply would not increase.

But what about the federal government? Its demand for credit is not sensitive to the level of interest rates. Yes, but the Fed could continue to raise the rate it pays on reserves until the quantity of credit demanded by the private sector falls sufficiently to offset the increased demand for credit by the federal government. But might this imply a substantial increase in interest rates? Yes, it might, depending on the sensitivity of private-sector credit demand and the amount of borrowing by the federal government.

Would not this “crowding out” of private sector borrowing by federal government borrowing be a negative for future productivity and economic growth? Yes. But that’s a different issue. The point I am attempting to make in this commentary is that the increase in the Fed’s balance sheet in the past year is not currently inflationary and need not lead to higher future inflation. Whether the Fed has the will or the skill to prevent the current increase in its balance sheet from manifesting itself in future higher inflation also is a different issue.

Source: Paul Kasriel, Northern Trust - Daily Global Commentary, June 29, 2009.

*Paul Kasriel is Senior Vice President and Director of Economic Research at The Northern Trust Company. The accuracy of the Economic Research Department’s forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul’s 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst.

Tags: 12 Months, Alan Greenspan, Arthur Laffer, Balance Sheet, Billions Of Dollars, Depository Institutions, Economic Commentators, Excess Reserves, Explosion, Federal Government, inflation, Interest Rate, interest rates, Loan Rate, Loans, Money Supply, Northern Trust Company, Paul Kasriel, Raw Ingredients, Unprecedented Increase
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How to play a stock market correction

Tuesday, July 7th, 2009

Stock markets might just have finished a particularly strong quarter - with the S&P 500 Index gaining 15.2% for its best quarter since 1998, the MSCI World Index rising by 19.7% and the MSCI Emerging Markets Index adding 33.6% - but started to look tired last month, and July is also off to a shaky start.

Volume has been declining on rally days and expanding on declining days, which can be construed as bearish action. On July 2, Lowry’s Buying Power Index closed one point below where the Index was at the March 9 stock market lows, i.e. Buying Power is now weaker than it was at the early March bottom.

As doubts persist over the strength of the global economic recovery, the S&P 500 Index, MSCI World Index and MSCI Emerging Markets Index have dropped by 5.0%, 5.9% and 6.3% respectively from their June highs.

Regarding the US markets, an excellent contrary indicator worth keeping an eye on is the CBOE Volatility (VIX) Index. The Index peaked at 52.7% in early March, coinciding with the rally lows, and has since declined by more than half. However, the Index seems to be bouncing off a support line while the Commodity Channel Index (CCI) - a momentum-type oscillator - has turned up from an oversold level for the first time since last May. This would indicate the end of the stock market rally.

Source: StockCharts.com

Considering the percentage of global stock markets trading above their 50- and 200-day lines respectively makes for interesting analysis. Most countries (89%) are trading above the 200-day average - an indicator of a bullish primary trend. As far as the secondary trend is concerned, 55% of the countries are still trading above the 50-day average, having corrected from an overbought level of 100% a few weeks ago. One would typically expect this measure to decline to lower levels in order to more fully correct the massive spring rally.

David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates, said: “… for the near-term … the testing process [for the S&P 500] does seem to be in place right now and carries with it some well-established investment patterns. Over the last year, we have seen four other testing phases and they all failed as the market did break to new lows. With the proviso that the S&P 500 hit an interim peak of 946 back on June 12, here is what the recent historical record tells us to expect (at a minimum, take profits).

• “The average length of the testing phase is 53 calendar days and 38 business days (versus 45 calendar days and 33 business days for the interim bear market rallies).

• On average, the S&P 500 undergoes a correction of more than 20%.

• The sectors that led during the rally, corrected most during the sell-off. This means that financials, consumer discretionary, materials and industrials should underperform in the next few months, while health-care, consumer staples, utilities and telecom services should emerge as the leaders.

• Market volatility more than doubles, on average.

• Bonds rally, with the 10-year Treasury note yield down nearly 15 basis points, on average.

• The flight to safety during these periods implies that the Canadian dollar declines (on average by 10%), while the trade-weighed US dollar rallies by more than 6%.

• Commodity prices decline by an average of 15%, again as cyclical trades unwind.

• Corporate spreads (Baa) widen by an average of more than 60 basis points; it is very important to be focused on high-quality paper during these market-testing periods as high-yield spreads widen, on average, by more than 300 basis points (and keep in mind the vast outperformance, which is typical during bear market rallies).

• What we discovered during this process was that gold performed quite well during both the bear market rallies and the subsequent selloffs (and despite the flows back in the US dollar). This may be an indication that gold is in a secular bull market.”

Rosenberg concludes: “We found that health care, staples, utilities, high-quality bonds and the US dollar work best during these retests.”

Meanwhile, Teun Draaisma, highly-regarded equity strategist at Morgan Stanley, argued there are “plenty of opportunities to make money beyond the market direction call” by pursuing a strategy that he describes as “the middle ground”, as reported by the Financial Times.

“Macro and the next big market move have become everyone’s favourite investment topic over the past two years. We suspect it is time to move on to the micro of sectors, stocks and styles,” he said.

Draaisma’s large “middle ground” of investment opportunities include “the forgotten market” Japan and “sectors that are cheap and under-owned with improving fundamentals” such as utilities, telcos and energy. Also “buying stocks with a management change, financial restructuring or a change of focus can be very lucrative”.

I said the following on Sunday in my “Words from the Wise” review: “In my opinion, US stock markets are mapping out a base development formation, whereas a number of emerging markets have already bottomed out and subsequently confirmed primary uptrends. However, in the short term it is quite likely that markets could consolidate further and possibly retrace more of the prior gains.”

While investors wait for Mr Market to show his hand, a cautious approach is warranted but that should not preclude one from finding stocks that look cheap.

Tags: Canada, Cboe, Chief Economist, Commodities, Commodity Channel Index, David Rosenberg, Economic Recovery, Emerging Markets, Global Stock Markets, Gluskin Sheff, Lowry, Lows, Market Rally, Msci Emerging Markets, Msci Emerging Markets Index, Msci World Index, Oscillator, Power Index, Rally Days, Spring Rally, Stock Market Correction, Strategist, Volatility
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WealthTrack’s Great Investors: A Conversation with Bill Gross

Tuesday, July 7th, 2009

In this first edition of a new WealthTrack series on great investors, Consuelo Mack sat down with “Bond King” Bill Gross, co-chief investment officer of bond giant Pimco, and discussed how he was reconciling his big-picture, secular views of lower investment returns with his higher-return-oriented investment goals. Amongst others, he told her why he was backing away from his investment strategy of making the government his investment partner - a key theme of Pimco’s over the past year - and what he was focusing on instead. Gross also shared what he is doing with his own money.

Gross’ flagship Total Return Fund was up 4% plus last year, nine full percentage points better than its peers. It is up more than 6% for the year to date, again outstripping the competition. Not too shabby!

Do not miss any of this great interview.

Note: The transcript of this interview is not available yet, but will be posted here as soon as it arrives.

Source: WealthTrack, July 3, 2009.

Tags: Big Picture, Bill Gross, Bond Investment, Cape Town, Chief Investment Officer, Giant, Gross Co, Investment Goals, Investment Partner, Investment Returns, Investment Strategy, Investors, Mack, Money, Peers, Percentage Points, PIMCO, Postcards, Sat, Target, Wealthtrack
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