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Today's Market WrapUp |
Managed Markets And a Managed Economy
In many eastern economies around the globe and in parts of Europe and Latin America, we have centrally planned economies. Government, and not the marketplace, plan the economic activity of the nation. In the West, we have Central Banks that plan our economy and it now appears our markets. The booms and the busts are predetermined by the actions taken by the Central Bank of a nation. Whether to inject liquidity into the financial system to bail out a bank, hedge fund or a foreign nation has now become part of a Central Bank's job. The amount of credit or the cost of that credit is also now centrally planned. Rather than let the marketplace determine how much credit is needed and what its cost will be based on, available savings is no longer a factor in our debt-based economy. Today our markets and our economy are planned and microscopically analyzed down to the smallest statistic. Indeed a major criticism of U. S. economic thinking is its heavy reliance on statistical measures in planning the economy.
In the past few years, the occasion has arisen that perhaps our own financial markets were also planned. Intervention in the markets was an objective of the Plunge Protection Team, which emerged as a result of the 1987 stock market crash. Its purpose was to intervene in the markets to prevent another repeat of the October 1987 crash. Now we are told in a formal manner, that the Fed will intervene more forcefully in the bond markets in an effort to peg interest rates and prevent deflation from occurring in the U.S. If lower rate cuts don’t work, and they haven’t so far, then the Fed has other tools at its disposal. One of those tools would include buying Treasury bonds in an effort to drive down long-term interest rates. One would have to wonder if that in fact has already occurred. Daily graphs of the dollar, the bond market, and the major stock indexes reflect on numerous occasions a sudden vertical takeoff when a market appeared to be in danger of collapsing. Please refer to James Sinclair’s editorial from last Friday. It shows multiple examples of intervention on all fronts after the unemployment rate jumped last month.
These inventions or miraculous recoveries tend to take place at the opening bell or during the final hour of trading. The graphs of the 30-year bond, the Dow, and the S&P 500 often are characterized by these miracle turnarounds. For the skeptics of intervention, I would suggest reading Fed Governor Bernanke speech given several weeks ago that is archived on our FedWatch resource page and the International Finance Discussion Paper No. 641, July 1999. In this paper, the Fed researchers discuss various ways and measures that can be taken to influence the outcome of markets -- whether it is currencies, interest rates and bond prices or the stock market. The following are notable quotes from that research paper that outline steps to be taken when interest rates are at zero or when real interest rates are negative.
"Purchasing Treasury Bonds
Perhaps the most obvious extension of a central bank’s policy actions beyond the purchase of T-bills is to engage in the open market purchase of longer-maturity government debt. The effects that such actions can be expected to have on longer-term Treasury rates depend on how one sees interest rates as being determined. Following fairly standard views, we view long-term Treasury rates as composed of expectations of future short-term interest rates and term premiums. To have an impact, open market operations would have to affect at least one of these two components….
Therefore, it would seem, that bond purchases would have to affect interest rates through impacting term premiums. Purchasing bonds, and decreasing the public’s holding of bonds, can decrease the term premium if bonds and other assets are imperfect substitutes in the public’s portfolio. In order to induce the public to hold fewer bonds, the central bank would bid up the price of those bonds and thereby lower their yield. However, historical evidence, such as Operation Twist in the United States in 1961, does not seem to support this notion of significant interest rate effects stemming from changing the relative supplies of assets. But, it remains an open question as to what the effects would be of truly massive purchases of government bonds. A central bank could presumably overwhelm the markets and raise Treasury bond prices. Indeed, the Federal Reserve fixed the yields on U.S. Treasury securities during and immediately after World War II. Presumably, bond purchases on a large enough scale could drive Treasury bond rates to zero, or nearly so." [International Finance Discussion Paper No. 641, July 1999 Monetary Policy & Price Stability link to pdf report] (p. 24)
"Writing Options
With long-term interest rates importantly affected by expectations of future short-term rates, a central bank may find interest rate options a valuable tool for affecting longer-term interest rates. With options, a central bank can convey its intentions regarding the future course of short-term rates. In particular, the central bank could enter options contracts in a way so that if future short-term interest rates rose above a specified level, the central bank would be obligated to make a payment to its counterparty. Not only would this inject reserves when interest rates rose, it would penalize the Federal Reserve for its failure to keep rates low. And the private market would gain financially --- the options would essentially be providing some insurance should short rates rise above the specified levels.
To accomplish these goals, the central bank would be the party to write the option and would set the strike price to correspond to the particular interest rate ceiling (i.e. a specific floor for T-bill prices) it desired to convey to the market. Then, if market rates were to rise above the ceiling rate, the price of the Treasury bill would fall and the holders of the option would have an incentive to exercise the option---purchasing a T-bill at a low price in the market and “putting” it to the central bank at the higher strike price.
Options not only provide a way for the central bank to specify its ceiling for a particular interest rate over a specified future period, but the day-to-day changes in the price of the option also provide a market-based index of the credibility of the particular interest-rate ceiling specified in the options contract. Should the central bank’s commitment to low interest rates be questioned in the market, the central bank could read this from the option prices and could attempt to provide a policy response--either with options or other instruments." (p. 25)
On Influencing Exchange Rates
"Purchasing Foreign Exchange
By purchasing foreign exchange, a central bank could hope to depreciate its currency and spur net demand for domestic goods and services. When interest rates are above zero, unsterilized intervention causes more depreciation than sterilized intervention.21 This is because an unsterilized intervention lowers the domestic interest rates, whereas a sterilized intervention does not. However, at the zero bound, the two types of intervention have the same effects because the unsterilized intervention cannot lower the interest rate.
With risk neutrality and current U.S. interest rates fixed at zero, foreign exchange intervention could cause the dollar to depreciate in the current period if (and only if) it caused private agents to expect the dollar to be depreciated more in the future than they expected it to be before the intervention. At issue is whether U.S. authorities could create expectations of a future depreciation by credibly signaling their intentions for the future course of the short-term nominal interest rate. If U.S. authorities sold dollar assets in the current period and used the proceeds to purchase foreign assets, they would stand to gain if the dollar were to depreciate in the future. Observing current foreign exchange purchases by U.S. authorities, market participants might expect the U.S. authorities to lower interest rates in the future to bring about this depreciation. If so, with interest rates in the current period fixed at zero, the dollar must depreciate in the current period in order to maintain interest rate parity. The empirical literature provides only limited support for the existence of such signaling effects and suggests that if they are present at all, they vary from episode to episode and disappear fairly quickly.
Alternatively, foreign exchange purchases could succeed in causing the dollar to depreciate if U.S. and foreign assets are imperfect substitutes because agents are risk averse. In effect, changes in relative supplies of assets would then affect relative returns, and by purchasing foreign exchange, the Federal Reserve would be increasing the supply of dollar-denominated assets relative to foreign assets. However, an extensive empirical literature has almost universally concluded that such relative supply effects have little or no lasting impact on exchange rates." (p. 25-26)
Intervening IN the Private Sector
"Purchasing Private-Sector Securities
While using a credible rule to set short-term interest rates, purchasing government bonds, and using options may all help to lower and flatten the Treasury yield curve, the yield curves for private sector securities could remain somewhat elevated. In particular, if short-term Treasury rates are at zero and the economy is floundering, credit risk premiums could be quite high. If these risk premiums are holding back an economic recovery, the central bank could potentially unlock credit flows and jump start the economy by taking this credit risk onto its balance sheet, for example, through purchases of private sector securities. The key issue for a central bank contemplating such actions, however, is whether it is authorized to and whether it wants to take such private-sector credit risk onto its balance sheet.
The Federal Reserve, for example, faces some important restrictions regarding the type of private-sector securities that it is authorized to purchase. The current statutory authority for open market operations is still strongly influenced by the intent of the original framers of the Federal Reserve Act. One intent of the Federal Reserve Act was to spur the development of the bankers’ acceptance market. It was thought that if the Federal Reserve could purchase and sell bankers’ acceptances and similar types of securities, this would stimulate the development of private markets for these types of credit instrument. Accordingly, even today, while the Federal Reserve can purchase virtually all types of Treasury and agency securities, it can purchase only certain types of private sector securities---bankers’ acceptances and bills of exchange. Accordingly, the Federal Reserve is not authorized to purchase notes, such as corporate bonds and mortgages; nor can it purchase equities or real property such as land or buildings..."(p.26-27)
As mentioned above, a key aspect of the purchase of any asset by a central bank would be whether the central bank can take onto its balance sheet the credit risk inherent in the asset. For open market purchases, there does not seem to be any explicit instruction that the Federal Reserve can not take credit risk onto its balance sheet. The limitation to taking on credit risk would seem to stem from the types of instruments that it can purchase--namely bankers’ acceptances and bills of exchange arising out of real commerce. In practice, the Federal Reserve has stipulated that, as stated by Woelfel (1994), “a bill of exchange is not eligible for purchase until a satisfactory statement has been furnished of the financial condition on one or more of the parties.” This condition, if not changed subsequently by the Federal Reserve, would seem to limit the private-sector credit risk the Federal Reserve would be taking onto its balance sheet by way of open market operations." (p. 27)
On Creating Wealth
"Printing Money to Induce Wealth Effects
When interest rates are positive and policy actions lower them, one channel through which aggregate demand is raised is the wealth effect generated by higher asset prices. But if interest rates are at the zero bound, then there are no wealth effects from the open market operations in these assets. This leaves wealth effects operative only if the central bank can directly engineer increases in wealth either by purchasing assets at above market values or by “printing” money and somehow distributing it to the public as a transfer payment. Regarding the purchase of assets at above market values, this would appear to be problematic, at least on the political level if not on legal grounds. Deciding which types of assets to purchase at above market value would entail distributing wealth to some members of the public and not others based solely on their asset holdings. However, on strictly legal grounds it would seem possible for the Federal Reserve to purchase assets at above-market prices even if this results in negative interest rates on those purchased assets.
Printing money and distributing it to the public probably is not legal under the Federal Reserve Act. Under the act, after all expenses have been paid and the stockholders have received a dividend of 6 percent, the net earnings of the Federal Reserve must be put into a surplus account. It appears that direct transfers from the surplus account are not authorized by the Act. Even if allowed, the printing of money would entail issues of fairness and equity: would checks be mailed out to individuals, or would money be given to deposit holders through depository institutions? Questions affecting the distribution of wealth may best be left to the political process. The printing and distribution of money could have to be achieved in conjunction with the political process by means of a money financed reduction in income taxes. But any such action can be seen as composed of two components--a tax cut financed by new issuance of Treasury bills and an open market purchase of the bills. Since the later effects are likely to have little effect at the zero bound, the total effect would come from the fiscal stimulus. Of course, if the fiscal stimulus were large enough to raise the nominal interest rate above zero, then standard open market operations would regain their stimulative impact." (p. 17-28)
After reading excerpts from this research paper which laid the groundwork for intervention, should interest rate cuts fail, it is with particular interest that I noted today the investment strategy of one of the leading bond fund managers of this country’s change in investment posture. In their latest Fed Focus, Pimco’s Paul McCulley outlined the firm's strategy to focus on corporate debt and Euro-denominated debt as a result of the change in strategy at the Fed. In a column directed to shareholders and potential clients, Pimco shows a graph of the corporate bond market with the title “The Bernanke Put Applies To Corporate Bonds” as shown below. The gist is that the Fed’s ability to fix rates at the Treasury level also applies to the corporate bond sector.
http://www.pimco.com/
Source: Fed Focus by Paul McCulley, "Necking in the Mezzanine," December 2002
In summation, McCulley is ecstatic at the change in policy at the Fed. In McCulley's view, the Fed’s war against inflation is over and Greenspan declared victory on November 13. To paraphrase McCulley, the battle for inflation is over and that capitalism and democracy will be operating in a controlled environment where the Fed keeps the printing press. There will be no deflation because of the cost and price that deflation would inflict on the economy and the financial markets.
Essentially, the gist of the Fed’s latest policy changes and the reaction by Wall Street to them suggest that the financial markets are content to operate in markets where prices are controlled, supported and manipulated as to their outcome by government. When I began my career in this business, the financial world would have been horrified by the possibility of such massive intervention and its inflationary consequences. Now they salivate at its prospects.
One has to think how much the financial world has changed over the last two decades. It appears that Washington and Wall Street have become fully infected by the ghost of John Maynard Keynes. The phrase by Richard Nixon that, “We are all Keynesians now.” has never been truer. The fact that financial markets have become inflated, there is a bubble in bonds, mortgages, and real estate and consumption, and that there is a record amount of debt in this country is looked upon as signs of a robust economy. Instead, it should be raising concerns and alarm bells that something has gone amiss in our society.
It is "Acceptable"
Current thinking has changed it's tune. As long as inflation takes the form of inflating asset bubbles, it is acceptable. If inflating the money supply inflates stock prices and creates a bubble, then it is acceptable. If a new credit boom inflates mortgages, the bond market, consumption, and real estate, that is also a good thing. No one has asked, What happens to those mortgages when the people who have to make those payments lose their jobs? No one has asked, What happens, when delinquencies and defaults rise (as they are currently), to all of those paper asset securities or the assets that back them? We now think that we can borrow and spend our way to prosperity and that the price of all asset markets can be artificially stimulated and controlled.
Is It?
We are truly living in historic times. The world of John Law is about to be merged with the world of John Maynard Keynes. The alchemists are at work and I’m not sure of what kind of monster they will create when this Grand Experiment is through. History shows us that the outcome won’t be pleasant.
Today's Market
In the meantime, a purview of today’s headlines reveals the same old news. There were continuing scandals with J.P. Morgan disclosing certain transactions with Enron as disguised loans. Insurance companies suing the bank said that Morgan masked loans as oil and gas trades.
The giant California pension fund, Calpers, fired Merrill Lynch and Credit Suisse after high single-digit losses this year. Personal portfolio turnover was cited as the reason for letting Merrill Lynch go; while a disagreement over currency hedges and investment strategy was the reason for terminating Credit Suisse. Calpers also put J.P. Morgan Fleming and Oak Associates on its watch list.
Despite the usual earnings warnings, stocks rose at the opening bell and then got a miraculous push in the final hour. The reason for optimism after yesterday's big selloff was a survey of economists projecting big gains in capital spending next year. Why stocks rallied on this hopeful projection is anybody’s guess. The economists have been wrong about everything in this post-bubble economy. The hopeful projection that business will spend a lot of money on capital investment next year helped tech stocks to rally today after plunging yesterday. Shares of GE rose $.43 to $25.93 on hopes that it will experience double-digit growth perhaps as soon as 2004. So we are now discounting stocks on the basis of earnings two years from now. That way they look cheaper.
Another reason given for today's market performance today was the steady hand at the Fed which met in Washington. The Fed left interest rates unchanged. In a statement accompanying the meeting, Fed officials said that the economy should resume steady growth without the need of another rate cut. The FOMC continues to see the risks to the economy as balanced between inflationary pressures (bubbles) and economic weakness.
Volume came in at the low end of the spectrum with only 1.25 billion shares on the NYSE and 1.46 billion on the NASDAQ. Breath was positive by 21-10 on the big board and 20-13 on the NASDAQ. The VIX fell 2.80 to 31.67 and the VXN dropped 1.23 to 51.75. Technical indicators still point to near-term weakness with a drop in 5-10 day RSI, falling momentum, a drop in the McClellan Oscillator and the rise in the Eliades New Trin, and a fall in the 10-day CBOE Put/call ratio. All three major indexes have fallen and broken trendline support.