Wednesday, March 18, 2009

I suppose I could hot wire this thing...

I expect the Federal Reserve to announce a program to buy long-term U.S. Treasuries. If not at today's meeting, then soon. Interestingly, most commentators I read don't expect the Fed to move in this direction, but to me it seems too easy not to do it.

The Fed's big fear is deflation. We know the Fed has had the printing presses in high gear for several months now, yet still consumer prices barely move. Today we got CPI, a meager 0.2% over the last year. The cash the Fed is producing isn't turning into consumption. As I've said many times, if consumers don't spend more money, at least nominally, there can't be inflation.

Inflation nuts like to complain about the rapid growth of monetary aggregates. M2 for example has risen 9.8% in the last year, or $736 billion dollars. But note that this has almost all translated into excess reserves at banks, which have gone from about $1 billion a year ago, to $622 billion today. In practical terms, money available for consumption is falling.

If the Fed wants to create inflation, it is going to need to overwhelm banks desires for additional excess reserves. That's going to be very tough given that banks are looking at continued increases in loss reserves (despite Citi/BofA's claim that they are profitable). BCA is predicting an additional $1 trillion in losses at banks before the credit crisis is over.

To this end, the TALF is great idea. This program aims to stimulate consumer lending directly, bypassing banks, by reinvigorating the asset-backed securitization market. Already Nissan is doing an auto loan securitization tomorrow, and another major manufacturer is going to follow suit this week. These two deals will combine for $5 billion.

That's all well and good, but it won't address the problem that consumers might not want to borrow. Household liabilities are currently 134% of disposable income, according to the Fed's Flow of Funds report. In addition, households have also seen their net worth decline by $13 trillion. Consumers must continue to save aggressively in order to offset these losses. And despite what some Keynesians say, consumers need to have a decent asset base before a lasting recovery can take hold.

But a lasting recovery can't happen under deflation. Deflation has more destructive power than half the starfleet. Deflation will push home prices even lower, thus exacerbate the problem of negative home equity specifically, and wealth destruction generally.

Currently the Fed is buying Agency debt and Agency mortgage-backed securities (MBS). That program has been a success so far in bringing down spreads on those bonds, especially considering the massive flight away from these securities by foreign buyers.

But that's just the thing: the Fed has brought down the spread on these bonds. The Fed program has helped prevent mortgage rates from rising in recent weeks as Treasury rates rose. But we won't see mortgage rates actually fall until Treasury rates fall. Remember that MBS typically have servicing spread of 50bps, meaning that if investors will buy MBS with a 5% coupon, that translates into a 5.5% actual mortgage rate. So if the Fed wants to see mortgage rates at 4.5%, they have to get investors to buy mortgage bonds at 4%. Investors simply aren't going to buy a mortgage security at a 4% yield if the 10-year Treasury is at 3%.

Forcing Treasury rates lower will be relatively easy. The Bank of England has already set the precedent. On March 5, the Bank of England announced it would be purchasing up to £75 billion in gilts over the next three months. The day after the announcement, even before the first actual purchase, the 10-year Gilt had already fallen by 30bps.

When Treasury yields fall, it puts indirect pressure on all other yields. No other segment of the investing world is so instrumental in pricing so many other investments. The Fed could buy MBS, and bring MBS rates lower, then buy corporates to bring those rates lower, then buy ABS, and munis and CMBS, etc. etc. Or it can just buy Treasury bonds and bring all rates lower at once.

Not only would forcing Treasury yields lower be impactful, it would also easier to achieve. The MBS market is about $8.9 trillion and is made up of thousands of individual securities. By contrast, there is only one 10-year Treasury bond, with about $40 billion outstanding. All the Fed has to do is target the 10-year Treasury and all rates will react substantially from there.


Hawkeye0915 said...

Great stuff as usual AI. Question for you, or for other readers who might know - in the Nissan auto loan deal, when you say they are bypassing the banks, do you mean Nissan itself is making the auto loans? They're not using a bank to do it?

Unknown said...

AI said..""As I've said many times, if consumers don't spend more money, at least nominally, there can't be inflation.""

Inflation has three parts...Too much money...chasing....too few goods.

It's the chasing part where we have a problem.

Accrued Interest said...

The Nissan deal was supposedly all sold before they even announced Nissan was the originator.

Anyway, Nissan Motor Credit is lending money directly to consumers. In the absense of securitization, NMC gets their cash from a bank. With securitization, they can lend directly, getting money from investors. Make sense?

Christopher Wheeler said...

I think the central issue is the household debt stuck at 134% of disposable income. Until households delever a lot more, you aren't going to see a pickup in spending.

One way of looking at the stimulus package is that it is a way to keep household incomes up while his process plays out.

AI, I think you pointed out in an earlier post that everyone in the global system was trying to deleverage all at once, and only the Federal government was in a position to pick up the leverage that others were attempting to dump.

pwm76 said...

I understand the deflationary argument.

But if inflation reasserts itself more quickly than expected, say through a fall in the dollar, wouldn't mortgage bonds at 4% be a terrible thing to own? On top of the interest rate risk, there is the considerable extension risk. If you are leveraging up to buy them, as I know some funds are doing right now, there is also the risk of the attractive short term funding disappearing.

What is the exit strategy for the Fed?

Accrued Interest said...


I absolutely hate MBS here. All risk no reward. I'm minimal weighted in my portfolios.

That being said, there are a lot of buyers who don't care about marks, just that they earn income. MBS fit that bill.

capitalhill said...

"The TALF is great idea."

Here's my questions about the TALF: Who's going to buy the mezz and equity pieces of these deals?

Accrued Interest said...


I think most of these deals will see the originator retain any sub pieces. I haven't heard otherwise anyway.

John (Ad Orientem) said...

I lost a much longer comment and don't have the time to reconstruct it. But in brief...

Re the perpetual discussion of inflation:

I just finished reading a fascinating article which seems to support Al's thesis that the monetary supply has been dropping. However this would appear to be predicated on the inclusion of much of the wealth that has been erased in the great crash. If any of that "lost wealth" rematerializes the situation could change quickly.

If ad argumentum the FED is successful in breaking the back of the deflationary spiral we have been in (I think they already have), then we could see a sharp revival in the financial markets. It is debatable whether the current rally might be the one I am contemplating or if it is just a bear market rally. But if/when the markets rally we could see two things. First the restoration of at least some of the vast lost wealth. And secondly a greater willingness on the part of banks to lend some of that money the FED has been handing them. In both cases we are discussing money that is beyond recall by the FED.

In short the ingredients for a potentially sharp uptick in inflation are out there. None of this of course is certain. But money once created and put into play can not be recalled. Raising interest rates sharply will not prevent inflation once the money is in circulation. It might limit the life of the inflation and mitigate its long therm severity. But that is all.

When addressing the issue of inflation we need to recall that throughout most of the Bush Administration the dollar declined in value and we saw a low level inflation that seemed to be picking up steam in the period immediately preceding last Fall's panic. In considering the question of a potential future round of inflation two questions need to be asked...

1. What were the underlying causes for the sharp decline in the value of the dollar during the Bush years?


2. Have those causes been negated by recent events, or is the recent rally in the dollar merely the consequence of a temporary confluence of circumstances which have left the underlying causes for dollar devaluation and inflation in place and waiting for the opportunity to reassert themselves?

Once we answer those questions we will have an idea of what might lie ahead. For my money I believe the decline of the dollar is merely on pause.