RBS’ Janjuah Shares 2010 Outlook (in Short-hand Note)

Thursday, January 21st, 2010

Courtesy of BusinessInsider.com, Bob Janjuah, Royal Bank of Scotland’s Chief Global Strategist, shares his outlook for 2010 - He really likes commodities - and anything Bernanke and King can’t print.

RBS: Not all sovereigns have bad and/or fast deteriorating balance sheets (as a result of highly risky fiscal and monetary paths). Core Europe, much of NJA, Oz, Norway, Brazil all spring to mind. I think that bonds, currencies, credit and equities in such parts of the world will (a) outperform their peer grp equivalent asset classes in the bad and/or fast deteriorating sovereign balance sheet zones, but (B) will do merely OK on an absolute basis.

Elsewhere I think hard assets, most obviously to me GOLD and even CRUDE, will do EXTREMELY well. Over the belly of 2010 I expect to CRUDE up at $100 and Gold up at $1500.

I like commodities, anything which Bernanke and King can’t print at the press of a button.

Q2/Q3 2010 is when we will see the S&P down in the low 800s or lower, Gold at $1500, Crude at $100, the euro.

XO Index up at 700/700+. We will see BUNDS massively outperform Gilts and USTs. In the 10yr, I expect the Bund/UST spread to be at least 100bps - ie, 10yr USTs to yield 100bps+ more than 10yr Bunds.

(REMEMBER: None of this has anything to do with actual near term CPI-style inflation - assuming of course YOU still believe the data or believe that the official data tells even a half of the whole story - but rather everything to do with rapidly deteriorating sovereign credit risk/debasement/monetisation/shattered & zero policymaker credibility all being priced into bond yields).

In a follow up, Bob Janjuah shares his profound update to his outlook for 2010 in this grammatically incorrect short hand note. He says we may have already seen the highs for the year as a result of the fact that everyone in the world is now tightening:

This section is courtesy of Tyler Durden, ZeroHedge.com.

Bob’s World: Equity Highs/Credit Tights For 2010 Already Seen?

After putting my 1st piece out since Nov just this week, I have been sitting here and thinking…Forgive me for indulging myself in a stream of my own consciousness, but here goes:

The NAHB Index was ugly, as was the UK Inflation data, the ZEW survey, AND the ABC Consumer Confidence release….we also saw CITI BoA as well as MS all ‘miss’….

And yet stocks were at/close to post March 09 highs and up over 1% on Tues in the US ….Very strange!! Whilst I have only a very small degree of doubt that the Fed/US Treasury PPT is and has been actively goosing the US equity mrkt since Obama said Stocks Were Cheap in March 09 (funny that!!), I was beginning to think that we were/are close to peak levels because at peak bubble levels the price action is most ‘irrational’.

AND THEN 3 things hit me - Bang, Bang and Bang…..3 VERY SIGNIFICANT things:

1 - The Chinese are tightening policy more aggressively then even I thgt they would, and the core of the EUROZONE are playing uber Hard Money with Greece

2 - The Obama defeat in Mass is HUGE…….even a freshman can figure out that ‘Obama’s’ defeat in Mass is a move towards a lame duck president AND, most seriously, is a move that will directly and indirectly cause de facto FISCAL TIGHTENING - the Republicans have seen some serious and seriously UNEXPECTED gains in Washington since Obama’s inauguration and are now at the point where they COULD block Obama’s fiscal recklessness….most seriously, the message out of Virginia, New Jersey and now Mass is that the Republicans will do really well in the mid-terms…they will do ‘really well’ because they are going on the tkt of anti-big govt, anti-bailouts to all, & anti-big deficits, all of which is clearly hitting the sweet spot with the US electorate….furthermore, Obama has become a guy who folks either perceive or believe (I’m in this latter camp) has merely bailed out Big Wall St & Big Corporate America, all at the expense of the lower strata of the US economy (the youth, Black and Hispanic people, the SME sector, regional banks) - Yes, that’s right, the very folks who voted Obama in……all he has offered these folks is healthcare, which is now in serious risk, and benefits, where his temptation will be to DO MORE HANDOUTS (including making up more airy-fairy ‘fake job creation schemes’ just to keep folks, technically, off of the unemployment data) but which the Republicans can now much more effectively challenge/block, and which they certainly WILL (IMHO) block post mid-term victories. Key however is that the Mass defeat means Obama and Summers MUST now have serious doubts abt their reckless policies.

3 - The FHA is TIGHTENING policy too (!!!) re its lending in response to its SHOCKING delinquency data and its now invisible capital base - by law FHA will require a BAILOUT!!!!!! This is DIRECT MONETISATION and mrkts won’t like it

SO, back to what I wrote earlier this week. It COULD be that the Austerity is coming ANYWAY & EVEN SOONER than I had originally thght thru a combo:
- of Euro uber-discipline (VA),
- pro-active China (tightening) policy shifts (VA),
- the commercial realisation that the US/UK consumer and housing mrkts are still in a deep deep hole where the fundamentals are getting worse and where lenders (are forced to) pull back even more/tighten money a LOT in order to stop the rot on THEIR OWN balance sheets (part VA, part IA), and, lastly & most importantly,
- maybe, JUST MAYBE, the People have spoken and the message is clear (clearly IA as far as policymakers are concerned). They DON’T want BIG GOVERNMENT. They DON’T want our currencies debased anymore. They DON’T want to bail-out everyone. They don’t want to pay even more taxes to fund bloated government and to fund entitlement pay-outs ad infinitum. Maybe the People GET IT. They may get the fact that the West, esp. the US/UK, CANNOT PRINT/BORROW/SPEND its way out of our hole. Indeed, they may get the fact that we in the West need a deep-rooted and painful restructuring of our economies away from consumption and dissaving, towards savings and investment. If you think abt it for just one minute, it ain’t that complicated. Yes it means less holidays and less consumption of rubbish we dont need. It means a painful period of higher unemployment whilst the Austrian cleansing is allowed to play out. But all of which will then create the platform for the next 20yr period of REAL growth, REAL wealth gains, REAL productivity gains & REAL innovation.

The US electorate, so far, is clearly shouting this message and Obama must be nervous. Clearly in the UK all will be clear in a few mths time. But the sense I have right now is that the political classes may be forced into austerity because its is what voters want. Wow! Lets See.

In terms of mrkts vs what I wrote on Monday, it may mean that the Q1 peak in risky assets that I was looking for MAY have already been seen this week. It is too soon to be too sure - I need to see 3/4 consec closes below 1120 S&P before I have a very high degree on confidence on this - but the distinct possibility IS there.

IF this does indeed prove to be the case, then I would expect to see a move in S&P thru 1080, 1030 and into the 950/1000 range over the rest of Q1. In this move credit does badly, esp. weaker rated credit, and govvies do well, as does the GBP and the UST. Why? Because the market will be pricing for lower grwth, and tighter money + smaller deficits esp in the UK and US).

Again, IF this is the path we are going to follow, I would be extremely surprised if we did not see at least 1 decent multi-mth counter trend rally, but I also think we see lower highs. So think S&P going form 950/1000 back up to 1080/1120 in Q2. The driver for this counter trend rally will be the mrkt belief that the grwth story can survive even with tighter policy. Lagging grwth indicators and overly optimistic fwd looking ’subjective’ indicators will support this, + also lower bond yields will provide ’some’ support.

HOWEVER, as Kevin and I remain convinced that the underlying grwth story for the US & UK - in fact, for the whole world - will be one of multi-yr grwth disappointment (esp. in the UK US) due to weak final demand/prvte sector balance sheet repair and due to the fact that the supposed driver for grwth for EVERY economy seems to be EXPORTS, yet NOBODY can tell who the end buyer is ( it AIN’T China!!), then the call remains that in H2 10, we will see the resumption of serious risk asset weakness, higher volatility, and strength in govvie mrkt - esp BUNDS.

Cheers, Bob

Bob Janjuah
Chief Markets Strategist
RBS Global Banking & Markets
135 Bishopsgate, London EC2M 3UR
Office: +44 20 7085 3249

Tags: 3 Things, Abc Consumer Confidence, Absolute Basis, Asset Classes, Balance Sheet, Balance Sheets, Bank Of Scotland, Bernanke, Bond Yields, Bubble Levels, China, Commodities, CPI, Credit Risk, Debasement, Emerging Markets, Eurozone, Gilts, Global Strategist, Gold, Hard Money, Inflation Data, Lame Duck President, Mid Terms, Mrkt, Nahb Index, oil, Peak Levels, Policymaker, Q3, Rbs, Recklessness, Royal Bank Of Scotland, Significant Things, Sovereigns, Tyler Durden, Uk Inflation, Us Treasury, Usts, World Equity, Zew
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Richard Koo: Lessons Learned from Japan’s Lost Decade

Monday, November 9th, 2009

Richard Koo, the world-renowned chief economist of Nomura Research Institute, discussed the lessons learned from Japan’s “lost decade” during a presentation at Center for Strategic and International Studies (CSIS). During his discussion, Koo suggested that government stimulus can play a key role in alleviating the problems of a balance sheet recession. Koo’s recent book, “The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession”, discusses these issues in greater detail.

Source: CSIS, October 29, 2009.

Tags: Advertisement, Balance Sheet, Center For Strategic And International Studies, Chief Economist, Decade, Holy Grail, Japan, Key Role, Lost World, Nomura Research Institute, Presentation, Recession, Richard Koo, Stimulus
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Chart of the Day: Any bets on the savings rate?

Friday, October 2nd, 2009

I published a post yesterday quoting Richard Koo, chief economist of Nomura Research Institute and author of Balance Sheet Recession, as saying American consumers are suffering from a balance sheet problem and will not increase consumption until their personal finances are back in order. The chart below, courtesy of Clusterstock, leaves scant hope that individuals will stop saving and start spending again anytime soon.

“For one thing, we’re way below the personal savings rate we saw in the early 70s, let alone the savings rate in the pre-Greenspan era. With the recent wealth shock and the aging population, there are a lot of folks eager to hold on to every last dollar they’ve got,” said Clusterstock.

Source: Joe Weisenthal and Kamelia Angelova, Clusterstock - The Business Insider, September 30, 2009.

Tags: Aging Population, American Consumers, Balance Sheet, Bets, Business Insider, Chief Economist, Consumption, Era, Greenspan, Last Dollar, Leaves, Lot, Nomura Research Institute, Personal Finances, Personal Savings Rate, Recession, Richard Koo, Shock, Weisenthal
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Koo: Government fulfilling necessary function

Thursday, October 1st, 2009

Richard Koo, chief economist of Nomura Research Institute, rose to prominence early last year with the publication of his fascinating book, Balance Sheet Recession. He has just been interviewed by the brilliant Kate Welling at Welling@Weeden. Although I have not yet set eyes on the interview, I am sure it is top class. However, Richard Russell (Dow Theory Letters) last week provided a taste of the discussion in his newsletter, some of which has been worked into this post.

Koo defines a balance sheet recession as one that emerges “after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets. In this type of recession, the economy will not enter self-sustaining growth until private-sector balance sheets are repaired”.

According to Koo, American consumers are suffering from a balance sheet problem and will not increase consumption until their personal finances are back in order. The banks are not lending mainly because nobody wants to borrow and, furthermore, the banks want to build their own balance sheets (raise cash) and get rid of toxic garbage.

Koo says it’s up to the government to make up for the private sector’s problems by spending and continuing to run deficits. Thus we would be “buying time” through government spending while the private sector has time to repair its balance sheets. He claims it is absolutely necessary for the government to spend and run deficits. If the government cuts back on its spending and stimulus, the US economy will swoon and more money will be lost than was lost during 2008-2009.

Again, when asked what would happen if the government cuts back on its fiscal stimulus, Koo replies: “Until the private sector is finished repairing its balance sheets, if the government tries to cut its spending, we’re going to fall into the same trap Franklin Roosevelt fell into in 1937 (a crushing bear market) and Prime Minister Hashimoto fell into in 1997, exactly 70 years later.

“The economy will collapse again and the second collapse is usually far worse than the first. And the reason is that, after the first collapse, people tend to blame themselves. They say, ‘I shouldn’t have played the bubble. I shouldn’t have borrowed money to invest - to speculate on these things.’

“But a second collapse affects everyone, not just the bubble speculators, and it also suggests to the public that all the efforts to fight the downturn up to that point - all the monetary easing, the low interest rates, quantitative easing - have failed and even fiscal policy has failed. Once that kind of mindset sets in, it becomes ten times more difficult to get the economy going again. So the fact that Larry Summers was talking about ‘temporary’ fiscal stimulus had me very, very worried. That whole Larry Summers idea that one big injection of fiscal stimulus will get the US out of the recession, and everything will be fine thereafter, probably led to President Obama’s saying he’s going to cut his budget deficit in half in four years.”

In summary, Koo’s message is that we will have an all-out recession if government spending and the budget deficits are cut back before consumers’ balance sheets have been restored and they start buying again. Does anybody still expect the economy to be coaxed back to recovery without pain?

Tags: American Consumers, Asset Price Bubble, Balance Sheet, Balance Sheets, Bear Market, Buying Time, Chief Economist, Dow Theory Letters, Fiscal Stimulus, Franklin Roosevelt, government spending, Necessary Function, Nomura Research Institute, Personal Finances, Prominence, Recession, Richard Koo, Richard Russell Dow Theory, Swoon, Weeden
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Is US hyper-inflation a clear and present danger?

Friday, August 21st, 2009

We hear a lot of concern that the Fed’s mushroomed balance sheet over the past two years is setting the stage for a 1970s style inflation here. So long as we have a fiat (a.k.a. Chrysler?) monetary standard, the threat of hyperinflation always lurks. But is the stage currently being set for such an eventuality? I do not think so.

Chart 1 shows the behavior of changes in the M2 money supply over the past 50 years on a year-over-year basis. After the Lehman crisis in the summer of 2008, M2 growth accelerated sharply. By January 2009, the year-over-year growth in M2 reached 10.1%. Although not quite matching the 13-1/2% M2 growth often reached in the 1970s, if sustained, 10% M2 growth certainly would have the potential to push inflation significantly higher. Although the year-over-year growth in M2 has decelerated to 8.4% in July, that rate of growth if sustained, could still pack plenty of inflationary punch. So, why am I still not worked up about the potential for a 1970s’ style of inflation?

Take a look at Chart 2, which plots the behavior of the M2 money supply on a six-month annualized basis. After the spike to 15.2% annualized growth in February of this year, in the six months ended July, annualized M2 growth was only 2.7%. Barring another surge in M2 growth, this sharp six-month deceleration in M2 growth implies a continued deceleration in year-over-year M2 growth and, thus, a reduced likelihood of a repeat of the 1970s high-inflation environment.

How is it that the explosion in assets on the Fed’s balance sheet from approximately $901 billion at the end of July 2007 to approximately $2 trillion at the end of July 2009 (see Chart 3) has not resulted in a sustained explosion in M2 money supply growth? Because of the extraordinary increase in excess, or idle, cash reserves on the books of banks. As shown in Chart 4, banks’ excess reserves soared from only $1.6 billion in July 2007 to almost $733 billion in July 2009. So, about 64% of the increase in Fed assets in the two years ended July 2009 was accounted for by the increase in idle cash reserves sitting on the books of banks. A further 8.5% of the two-year increase in Fed assets was accounted for by an increase in currency in our pockets and/or squirreled away in our safe deposit boxes (see Chart 5). This dramatic increase in the demand for “folding money” was likely the result of an extreme case of risk aversion rather than a preparation for a shopping splurge (other than for canned goods and ammo, perhaps).

Why have banks allowed idle cash reserves to pile up on their balance sheets? Several reasons. For starters, the Fed now pays them a nominal rate of interest to hold these idle reserves. But this is not the main cause of soaring excess reserves. The principal reasons are lack of capital and lack of demand from borrowers who might be able to stay current on loans. The banking system has experienced sharp losses in the past year and is about to experience a second wave of losses. These losses deplete bank capital. Without adequate capital, the banking system cannot create new credit. At the same time that banks are strapped for capital, they also are strapped for loan customers who are judged creditworthy (see Chart 6).

But, a year from now, the banking system is likely to be better capitalized and the demand for bank credit from creditworthy borrowers is likely to be rising. This is when we will have to start to be more concerned about that mountain of excess reserves sitting on the books of banks being “activated” to create new credit to the nonbank sector. If the Fed does not take steps to adequately neutralize these excess reserves, then the inflationary game will be on. I do not currently know how adroit the Fed will be in neutralizing excess reserves. Evidently those who are forecasting a return to 1970s style inflation do know. More power to them.

Source: Paul Kasriel, Northern Trust Daily, August 19, 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: 1970s, Balance Sheet, Cash Reserves, Chrysler, Clear And Present Danger, Deceleration, Eventuality, Excess Reserves, Explosion, fiat, Hyperinflation, inflation, Lehman, Likelihood, M2, Monetary Standard, Money Supply Growth, Punch, Spike, Trillion
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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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Is anyone minding the store at the Fed?

Tuesday, May 12th, 2009

In the video clip below, Rep. Alan Grayson asks the Federal Reserve Inspector General, Elizabeth Coleman, about the trillions of dollars lent or spent by the Federal Reserve and where it went, and the trillions of off balance sheet obligations. Coleman responds that the Inspector General does not know and is not tracking where this money is.

You can’t make up stuff like this!

Source: YouTube, May 6, 2009.

Tags: Alan Grayson, Balance Sheet, Elizabeth Coleman, Federal Reserve, Inspector General, Lent, Money, Trillions, Video Clip
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Paul Kasriel: Preferred equity into common equity – accounting alchemy?

Thursday, April 30th, 2009

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

Congress currently is in no mood to authorize more funds to help recapitalize the financial system. The Treasury says this will not be a problem. If financial institutions need additional capital from the taxpayers to remain solvent, the Treasury will simply shift the preferred shares it already owns in financial institutions to common equity shares. Voila - capital adequate financial institutions! Really?

Consider Balance Sheet One of hypothetical Gotham City Bank. Assets equal liabilities plus common equity. That is good for starters.

But suppose the Treasury believes that Gotham should have a ratio of common equity to total assets of 10% rather than the 5% it currently has. No problem. Treasury will just convert $5 of the preferred shares it owns in Gotham to $5 of common equity. This is shown in Balance Sheet Two.

Now Gotham is well capitalized, right? Wrong. The depositors and the bond holders always were in line in front of the preferred shareholders in case Gotham had to be liquidated. So, moving $5 from the preferred equity category to the common equity category does not make the depositors and bond holders any better off.

Are taxpayers any worse off? Not really. If Gotham’s original $5 of common equity was not going to be enough of a cushion to protect depositors and bondholders, then taxpayers were not going to get all of their preferred-share holdings back anyway.

Now suppose that $30 of Gotham’s loans and investments become uncollectible, as shown in Balance Sheet Three. This means that all of Gotham’s common equity has been wiped out. In fact, Gotham now has an equity “deficiency” of $20. No problem, according to Treasury. It will simply convert its remaining $10 of preferred equity to common equity. That won’t cut it in this case. As shown in Balance Sheet Four, Gotham still has a common equity deficiency of $10. In other words, if Gotham were to be liquidated, there are only $70 of assets to pay off $60 of deposits and $20 of bonds. Either the Treasury would have to come up with $10 of new funds or bondholders would have to take a 50% haircut. If the Treasury wanted to keep Gotham open and with a ratio of common equity to total assets of 10%, Treasury would have to inject $17 of new funds, all of which would be common equity. In other words, Treasury, meaning us taxpayers, would own 100% of Gotham.

In sum, Treasury’s plan to enhance the capitalization of some financial institutions by beating preferred equity shares into common equity shares is accounting alchemy.

Source: Paul Kasriel, Northern Trust - The Econtrarian, April 27, 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: Accounting, Alchemy, Balance Sheet, Bank Assets, Bond Holders, Bondholders, Depositors, Financial Institutions, Investments, Liabilities, Northern Trust Company, Paul Kasriel, Preferred Equity, Preferred Share, Preferred Shareholders, Preferred Shares, Share Holdings, Starters, Taxpayers, Treasury
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Quantitative Easing: A Guide and Outlook to the ‘Nuclear Option’

Sunday, March 22nd, 2009

Last week, Ben Bernanke announced the Fed’s decision to employ ‘Quantitative Easing’ (QE), the ‘nuclear option,’ to save the credit market and the economy. On the news that the Fed will buy back up to $300-billion worth of long dated US treasury bonds, and acquire an additional $750-billion of mortgage backed securities, the US dollar plunged, the euro surged, Treasury yields nose-dived, gold bullion exploded, and stocks, oil and commodities gained handsomely.

We know what the immediate reaction has been to this, but what does it all mean in the longer term?

The main design of QE is to supply the money, by printing it, that is required to fulfill current demand for money arising from the deleveraging of balance sheets. Buyers need to be able to access credit and cash in order to purchase assets from distressed vendors. If purchasers cannot be facilitated via the market, the bids for the assets will keep falling until they can. QE means to provide the stop-gap measure. The other purpose of QE, is to make it possible for the Fed to enlarge its own balance sheet by assuming or acquiring ‘toxic’ assets in return for retiring debt from banker debtors, so that they can be freer to resume lending.

Until now, the deleveraging of market assets in favour of debt reduction has resulted in strong demand for cash, such that it has given the dollar a disproportionate boost - hence the strangely strong dollar.

Prior to the Fed’s move last week, this quote describes the current nature of the strong US dollar, from FT.com:

Hans Redeker at BNP Paribas said under normal circumstances, a rising deficit works against the domestic currency. “However, in this environment, deleveraging by institutions in order to clean up balance sheets will provide the dollar with a natural bid,” he said.

This deleveraging helped create a dollar shortage that drove the US currency sharply higher against the euro after the collapse of Lehman Brothers last September. Analysts said a similar situation seemed to be developing as equity markets plunged below their lows from last autumn.

The following is an excellent tutorial from Marketplace.com on Leveraging and Deleveraging:

Leveraging and deleveraging from Marketplace on Vimeo.
Quantitative easing supplies the cash via the printing press to those institutions in need of cash in return from the sale of levered assets, in the form of credit for buyers of liquidated assets. With credit for the purpose of re-purchasing distressed assets unavailable to would-be buyers, the market for those assets has suffered immensely; stocks, bonds, real estate, etc. As for the CDOs, only a daring breed of investors have shown interest, but they too may find it hard to get the credit to make it worthwhile, or the concessions and covenants.

The following is a tutorial from Marketplace.com on Quantitative Easing:

Quantitative easing from Marketplace on Vimeo.

Effectively, when you sell (or short) assets, the end result is that you end up long the cash. For those seeking to reduce debt, the cash disappears into the money pit, returning to the lender’s balance sheet. For those selling assets because they are risk averse, the money ends up for the time being in now zero-interest treasuries and short term cash equivalents. Therefore you end up with a strong dollar. When the market was over-using credit, it was short the dollar and the dollar was weaker. Now that the market is in a debt-reduction or deleveraging mode, it is long the dollar, therefore the dollar gains strength.

The Feds decision to employ the ‘nuclear option’ of QE sends a signal that there may be a great deal more deleveraging in store for the economy and there is substantial need to supply the money.

The immediate reaction is the weakening of the dollar, but that just provides temporary breathing space until the subsequent rounds of deleveraging sop up the slack created by QE, and what follows is a revitalized dollar, strengthened yet again by the deleveraging.

Graduated QE will periodically and gradually weaken the dollar, as it is dilutive, but the take up created by graduated deleveraging will gradually renew dollar strength. Ideally, if all the central banks in the G6 resort to this, there will be balance, but the timing may at times prove to be skewed by the independent agendas of the UK and the ECB.

The bottom line is that this first round of QE is just that. The first round. Bill Gross, Managing Director, PIMCO, points out that while it is a good move, it may not be enough, and that the Fed may have to expand its balance sheet to $5 or $6-trillion, as it takes $4 of debt to generate $1 of GDP growth.

Bill Gross: No, I agree with all of that. Its just a question, Kathleen, of ‘how big of a kick?’ There are a number of ways of looking at this. Goldman Sachs has approached it from the standpoint of the Taylor Rule, the deficiencies of output relative to their own particular index.

We look at it a little bit differently at PIMCO, we look at it from the standpoint of the amount of debt that’s required to produce a dollar’s worth of GDP growth. And up until 12-18 months ago in terms of our existing economy, that was about $4 of debt for $1 of GDP growth.

This $1-trillion dollars to our way produces $250-billion of GDP; that’s just under two percent real growth. That`s good, that produces in our opinion about 1-million jobs, but we need more than that.

KH: Is it enough to avoid the mini-depression you were talking about last month when I joined you for an interview out there at Newport Beach?

BG: We think so, you know yesterday’s move by the Fed were in recognition of this recessionary economy that could have resembled a small depression unless credit markets and risk taking were revived. And in fact the Fed labelled their policies ‘credit easing’ and you mentioned the obvious intent to lower mortgage rates to homeowners and lower credit card rates, auto loans, commercial rates as well so, you know, its very much of a positive push. We have sense that the $1.8-trillion balance sheet that the Fed has, that’s now growing to $3-trillion, probably will have to grow to $5-trillion and $6-trillion in order to keep us on a trend line that produces positive as opposed to negative growth.

Because QE measures may not yet be sufficient to completely overcome the problems facing the banking system in terms debt reduction the outlook continues to be tilting towards deflation.  As long as the need to deleverage balance sheets exceeds the availability of credit, assets could continue to deflate. Therefore, our sense is that the Feds first QE move is preliminary, and primes the pump for more QE in the next 6-12 months.

So, is the Fed’s move a signal that we are at an inflationary or deflationary inflection point for the moment? Watch the debate unfold between Hugh Hendry, and Liam Halligan. Then you decide…

We like to err on the side of reason and validity.

At the moment the political will to carry out this process fully, and further, faces significant opposition, especially to the idea of bailing out Wall Street and the US banking system, and is hobbled by the public outcry against the AIG bonuses debacle, and government has done as much as it can to suitably convince constituents of what it needs to do, for now. Today, the US Treasury announces a $1-trillion ‘public-private investment programme’ to absorb the toxic assets into what amounts to a ‘bad bank.’ One of the big issues is the competence of those in the private sector (which is meant to be a checks and balances component) to price these assets. Another issue remains whether or not this will get banks to release their chokehold on credit and resume business as usual in the lending business. The White House is expected to follow up this week with its comprehensive financial plan. This administration’s public relations programme has reached a crescendo; 60 Minutes, Jay Leno. Will they be able to finally stop talking and actually get down to work on it?

Does Geithner have the political ammunition to take further measures? Geithner must convince the market and constituents that this move will complement the Fed’s quantitative easing.

From today’s Globe and Mail: Nobel Prize-winning economist and Princeton University professor Paul Krugman blasted the strategy as a rehash of former treasury secretary Henry Paulson’s discredited solution to the banking crisis, first proposed six months ago. “It’s not new; it’s just another version of an idea that keeps coming up and keeps being refuted,” Prof. Krugman wrote over the weekend on his New York Times blog.

“It’s just horrifying that [U.S. President Barack] Obama - and yes, the buck stops there - has decided to base his financial plan on the fantasy that a bit of financial hocus-pocus will turn the clock back to 2006.”

The only way out of the banking crisis is for the government to offer a sweeping guarantee of problem debts and to seize control of banks with too few assets to cover their debts, Prof. Krugman argued.

The current crisis, he argued, isn’t just a panic, but a fundamental realignment of a financial system that foolishly bet big that house prices and consumer debt would continue rising forever.

For these reasons, QE and other measures will be a gradual process and could work, but only if taxpayers are willing to be saddled with the burden.

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Inflation is Tomorrow’s End-game

Friday, March 20th, 2009

There seems to be a fair amount of knee-jerk enthusiasm about inflation and inflationary assets, though according to some analysts, its too early in the offing to be taking a big stance in that direction. We’ve covered this off in many stories during the course of the year.

Everybody is reading from the same story book, but many of us are skipping to the end of the story, instead of fully appreciating the economic forces which have led to Fed’s decision to adopt quantitative easing, by adding a trillion dollars to its balance sheet. Bill Gross, PIMCO Managing Director, echoes that we will only see inflation as of 2010-2011. Here are some additional comments:

From Reuters:

Not all analysts agree the plan is a good idea or that it will cure what ails the heavily indebted economy, but many expect it to bring the benchmark 10-year note yield back down to the 50 year lows seen around 2.0 per cent seen last December.

“They can hold them down as low and as long as they want because they can print as much money as they want,” said Marty Mitchell head of government bond trading at Stifel Nicolaus in Baltimore.

“Yields can stay low and probably are headed lower.”

Inflation will ultimately become an issue, Mitchell said, but the more immediate concern was the prospect of a downward deflationary spiral in prices, wages and economic activity.

This means inflation is not on the agenda and will not be for at least a matter of months and possibly a couple of years.

“Inflation is tomorrow’s end game,” Mitchell added. “Right now they’re fighting off a deflationary environment.”

Mary-Ann Hurley, VP, Fixed Income Trading, D. A. Davidson says:

“While we’re not concerned about inflation right now, boy we potentially have a huge problem down the road. I don’t think it’s this year or next year’s problem but maybe 2011.”

“We’ve got a huge amount of stimulus and how is the Fed going to unwind all this? I can see a scenario where interest rates go up dramatically, which will hurt the economy. So, it’s a mess.”

Howard Simons, Bianco Research:

“We’ve crossed the Rubicon,” said Howard Simons, strategist at Bianco Research in Chicago. “We have absolutely severed any connection between our dollar and reality. It’s as fast as you can print it right now.”

The Feds decision is more likely at this stage to be bullish for bonds than for equities, as the rest of the developed world is forced to swallow the QE pill. There is also the age-old adage, “Don’t Fight the Fed.” If the Fed is buying bonds…for the time being in any case.

After all, how many of us really understand deflation?

Source: Reuters, Fed Plan May Lower Rates, But at What Cost?, March 19, 2009

Tags: Ails, Balance Sheet, Bill Gross, Bill Gross Pimco, Bond Trading, Deflationary Spiral, Downward Spiral, Echoes, Economic Activity, Economic Forces, End Game, Fixed Income Trading, Government Bond, Hurley, inflation, Lows, Managing Director, Marty Mitchell, Quantitative Easing, Reuters, Stimulus, Trillion, Vp, Wages
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