Tuesday, September 18, 2007

Look at the size of that thing!

50bps. I'm very surprised. There was plenty of chatter leading into today that 50bps was possible, but I figured if they had wanted to do 50bps, they would have made an inter-meeting cut.

I've talked a lot about the moral hazard issue, and I've made my opinion clear: I think its a non-issue. At least assuming they don't cut back down to 1%. Anyone who got an IO at a teaser rate in 2005-2006 is facing a serious reset regardless, so I really don't see where moral hazard comes into it. Do you think that John Doe home buyer took out that ARM thinking "Gee, if this goes against me, the Fed will cut rates again!" I don't.

Anyway, the markets obviously loved the news. I read the strong reaction from both high-yield and the stock markets as relief that the Fed is on top of things. But the bond market did give an indication about the risks of cuts as well. Both the 10-year and the 30-year bond actually rose in yield (fell in price) today. Why? Because inflation uncertainty just increased.

I'd like to see the Fed follow the 1998 playbook. Cut 75-100bps to prevent the liquidity crisis from expanding. Let banks get back into a position to make new loans to good borrowers, be that individuals or corporations. Don't cut so much that the bad banks don't feel the pain, because we need the bad loans wrung out. Then when the market has made clear that its strong enough to walk on its own, start hiking again.

In this scenario, I suspect the Fed will be forced to hike to a rate higher than 5.25%. This is what happened in 1999. After the Fed cut 3 times in 1998, it took all those cuts back and then some in 1999, and rate product had a terrible year. That's my outlook for the next 2-6 quarters. Fed cuts some more, but it doesn't help long rates, as investors remain weary of inflation. Then the Fed is forced to start hiking again within 2-3 quarters, eventually getting to 5.50% or beyond. The 10-year probably has 100bps or more of yield upside under such a scenario.

Hence why I like being short duration here. I know its contrarian to get short when the Fed is cutting. The old "don't fight the Fed" cliche. But the market is currently priced in a prolonged easing cycle. If it doesn't come to fruition, rates will wind up substantially higher.

A low risk way to play this is in the agency MBS market. MBS are basically short calls on long-term rates. In other words, MBS are kind of like the old covered call strategy, which tends to work best when the market is mildly negative. Besides, agency MBS are likely to benefit greatly from improving liquidity. I wouldn't touch non-agency MBS period.

You might be able to play in TIPs here too. I'd think TIPs would catch a bid here, as inflation worries rise. Unfortunately, I think the problem in TIPs is oil. Since TIPs are based on total CPI, its possible that core inflation rises because the Fed is supplying too much money, and yet oil prices come off their all-time highs, resulting in total CPI which isn't any higher. So I'd avoid TIPs, especially if you are a long-term investor.

I'm constructive on high-yield, but only because I think its fairly valued. If you are a long-term investor and understand that high-yield is susceptible to widening significantly in the short-term, then think about adding a small allocation. But I'd do it for the income, not assuming tightening.

The Fed is taking an awful risk here. This had better work.

18 comments:

psychodave said...

You keep saying "agency MBS". Are these from Fannie Mae or Freddie Mac? I'd always distinguished them from "direct obligations of the U.S. Government", like GNMA Project Loans, or short term paper from FHA or HUD, which I'd thought were meant by "agency."

Don't get me wrong. I think MBS guaranteed by Fannie Mae or Freddie Mac are as creditworthy as anybody in their right mind could want. But I thought there was to be a distinction, because their government support is implied, and not explicit.

Thanks.

Alan said...

How will the rate cuts affect the billions in the private equity pipeline that I think is just as responsible for the credit crunch as the subprime fallout? Will the big banks be able finally to get out from their bridge loans that have turned into long-term loans? Any word on the First Data deal or others that have been trying to get done recently? Alltel?

Scurvon said...

So lets play this out...

Market turmoil continues into the October Fed meeting.

Bond yields stay put or rise.

What can the the Fed do? If a 50 cut did nothing, a 25 basis point would appear pointless. Cut rates 100 bp? Give up and raise rates? Do nothing?

Regardless, their credibility will be in tatters. Could Bernanke be so naive that he missed this possibility? It seems inconceivable.

As you say, they better hope this works.

TDDG said...

"Agency" as used generically means Fannie Mae, Ginnie Mae, Freddie Mac, Federal Home Loan Bank, Federal Farm Credit Bank, TVA, Farmer Mac, and several others.

Is there a difference in credit quality between Fannie Mae and US Treasuries? Obviously yes. But Fannie Mae MBS have not moved wider than Ginnie Mae MBS recently. Ginnie's are full faith and credit of the US Govt.

Given this, why has the reverse rate between Fannie/Freddie MBS and US Treasuries spiked? No fundamental reason, its just a liquidity crunch.

TDDG said...

Private equity pipeline is a big problem, and this doesn't help at all. The rates on these loans were probably tied to LIBOR, so while the bank's funding is getting cheaper, so is the rate on the loan, so they aren't any better off.

See http://accruedint.blogspot.com/2007/07/find-controls-that-extend-bridge.html

and

http://accruedint.blogspot.com/2007/08/i-dont-know-fly-casual.html

and

http://accruedint.blogspot.com/2007/09/and-then-loans-just-float-away-with.html

TDDG said...

I don't think the Fed is worried about the fact that longer rates didn't fall. I think they just want the liquidity crunch to pass.

Anonymous said...

You're right.. they aren't worried about longer rates not falling.. because long rates have ALREADY RISEN.

That's the definition of capital flight, inflation, and several other nasty things. The market hasn't realized that yet because cognitive dissonance still has an effect.

flow5 said...

The federal funds bracket racket:
The buying and selling of Treasury bills, etc., under the auspices of the Manager of the Open Market Account through the New York Federal Reserve Bank for the accounts of all Federal Reserve Banks are tied to federal funds rates (read repurchase agreement’s rates).

As a guide to open market operations the rates are used as follows: a rise in the federal funds rate above the rate triggers open market selling operations. A fall below the rate, open market purchases. Open market operations of the buying type add (free gratis) legal reserves to the banking system; selling operations reduce reserves.

The technicians in charge of the hour-to-hour administration of open market operations apparently believe that there is, at any given time, a federal funds rate that is consonant with a proper rate of change in the money supply. They have in fact plugged this concept into a computer model, i.e., (a policy rule; or a "Taylor” like rule). What they have actually “plugged in” is an open ended device through which the commercial banks can decide whether or not there should be an expansion in the legal lending capacity of the banking system – the capacity to create credit (money) and to acquire additional earning assets.

That this expansion in money and credit will always take place is attested to by the insignificant amount of excess reserves held at all times by the commercial banks.

This has assured the bankers that no matter what lines of credit they extend, they can always honor them since the Fed assures the banks access to free legal reserves whenever the banks need to cover their expanding loans – deposits.

A clear distinction should be made between the temporary and the longer term effects of open market operations on the level of interest rates.

To hold down the Fed Funds rate (and other rates through this key rate), the Manager of the Open Market Account puts through buy orders for T-Bills or other eligible securities sufficient to yield a net increase in free, commercial bank legal reserves and free excess reserves. The Fed acquires these earning assets by creating free, new inter-bank demand deposits in the Federal Reserve Banks—that is by creating free legal reserves at the disposal of the commercial banks (IBDDs).

Assume the buy order is for T-Bills. The effect is to bid up their prices, reduce their discounts (interest rates) and add to free commercial bank legal and excess reserves. The expansion of free excess reserves increases the quantity of loan able “federal” funds thereby pegging or retarding the increase in the Fed Funds rate but the longer term effects of these operations are to fuel the fires of inflation.

An understanding of these temporary and longer term effects reveals why the tight money policy initiated in February 2006 brought about a continued upsurge in interest rates until 07/20/06 (30 year mortgages).. But it had the longer term effect of bringing inflation and interest rates down, i.e., until the beginning of the seasonally mal-adjusted time period (holidays).

The FOMC’s policy of seasonal accommodation has its roots in the fallacious “Real Bills Doctrine” (i.e., the injection of new bank credit for financing inventories at Christmas or any other phase of merchandising or processing is obviously inflationary when the theory is applied under the assumption that labor & facilities are fully employed).

Similarly, when the FOMC met on Sept. 18, they cut the federal funds rate to 4.75% -- a move that put the fed funds target rate significantly below 2007’s average daily repo stop-out rate (the stop-out rate was below 4.75%: 1x in Jun, 3x in Aug, & 1x in Sept).

At present, the FOMC may be able to temporarily control the short end of the market, (until Oct.), but in the long-run, the “trading desk” cannot control interest rates and will lose control of monetary flows (MVt) and inflation.

There is only one interest rate that the Fed can directly control: the discount rate charged to bank borrowers. The effect of Fed operations on all other interest rates is indirect, and varies widely over time, and in magnitude.

Under the current practices, the future holds no end to stop & go monetary management.

Anonymous said...

I am very interested in your comment:

The Fed is taking an awful risk here. This had better work.

What is the risk? What do you think will happen if it fails?

flow5 said...

Yes, the economy is slowing. But gdp ebbs & flows (see: seasonal accommodation/adjustments).

The FOMC's has forecasting problems because the research staff is always looking behind to set its course.

The Fed's research staff must be trained to look ahead. Then it would be obvious that the economy rebounds sharply in 4qtr/07.

It's unarguable that the Sept. 18, decision will cause the "trading desk" to "overshoot".

real inflation
gdp
---------------------
.0.04...-0.09...May
-0.04...-0.07...Jun.
.0.16...-0.09...Jul.gdp/infl/inters
.0.14...-0.13...Aug.
-0.09...-0.05...Sep.
-0.28...-0.12...Oct.gdp/infl/inters
.0.20...-0.16...Nov.
.0.55...-0.19...Dec.
.0.60... 0.06...Jan.

Jul. was the top. Oct. is the bottom.

Mick said...

I'm the Editor of Seeking Alpha - would you please shoot me off an email? I don't see any contact info on your blog.

Thanks,

Mick Weinstein
mick@seekingalpha.com

Applesaucer said...

Earlier this morning I posted an RDN-related question. I'm not sure where it ended it up, so on the off-chance that you've looked at it and respond, I won't see your answer. I'm too lazy to re-post it, though, so if you did get it via some automated email alert, then maybe you could answer it under this post if you've looked into it.

Many thanks,

Applesaucer

TDDG said...

Anon: I don't understand this statement:

"You're right.. they aren't worried about longer rates not falling.. because long rates have ALREADY RISEN."

Are you saying they aren't worried about rates rising because rates are rising? And you accuse me of cognitive dissonance?

TDDG said...

The "awful risk" is inflation. Or more particularly, that inflation expectations stay stubbornly high. For those who read my Taylor Rule post, I note that Median CPI is down to 2.7% YoY.

TDDG said...

Apple: I know RDN fairly well as a municipal insurer. They get involved in weaker muni credits, usually hospitals and industrial revenues. In terms of CDO/sub-prime exposure, their direct exposure is lower than most of the AAA insurers as a percentage of total claims paying ability. However, I think the CBASS collapse plus the perception that their risk management is weak has the CDS widening so much.

Anonymous said...

So, tddg:

How long before 30-yr bond rates are above 14%? And, of course, the correlary: How many Fed chairmen will we have to burn through to find another brave enough to be Volcker and raise rates so someone will invest in the US again?

More importantly, how many pairs of bell bottoms do you have?

The days of Jimmy Carter have returned!

TDDG said...

Mmmm... the blogger does not share your pessimistic appraisal of the situation.

flow5 said...

Nothing inflationary about today's H.3 release. Indeed, the Sept 12th statements are disinflationary.

It is counter-productive to rescue the economy by creating new money & credit. That means that rates-of-change in inflation will increase faster, relative to the rates of change in real-gdp.

How do you increase real-gdp relative to inflation, i.e, minimize stagflation?

You get the money creating Depository institutions out of the savings business. Why? The source of savings deposits to the money creating depository institutions is demand deposits, directly via the currency route or thru the banks undivided profits account.

Money flowing "to" the financial intermediaries actually never leaves the commercial banking system as anybody who has applied double-entry book-keeping on a national scale should know.

The growth of the intermediaries cannot be at the expense of the commercial banks. And why should the banks pay for something they already have? I.e., interest on time deposits.