Ben Bernanke: Smooth Criminal

I know this isn't a universally held opinion, but to me there is a simple reality. Between September and December we were facing a significant chance of another Great Depression. Beyond that, we were potentially looking at a financial disaster from which the United States would never recover.

Today, it looks like we are merely facing a very bad recession.

Who deserves credit? Certainly not Hank Paulson and the Bush administration. They choose philosophy over pragmatism every chance they got. They gave in to the moronic "moral hazard" bullshit argument. They stuck to their right-wing "fuck off and die" mentality toward the banking system. That worked out great didn't it? Then when they had the chance to use the TARP right, they failed miserably. Again, they gave into the moral hazard wing of the Republican party and instead of buying up bad securities, they initiated the Capital Assistance Program. No moral hazard there!

Can't credit Obama either. I'll admit that the Stress Test was a much better idea than anything Bush ever came up with, but I'd argue that by December we had already turned a corner. Obama just managed to keep the momentum going. Besides, his $800 billion stimulus program is, at best, a waste of time, and at worse, contributing to rising Treasury yields and thus retarding the recovery.

I have to give most of the credit to Ben Bernanke. He understood that while liquidity wasn't the whole problem, illiquidity could have made (and was making) the problem much much worse. He understood what really made the Great Depression a 15 year affair rather than a 2 year recession. He understood what created Japan's lost decade (and counting). He saw how dangerous debt deflation could be, and he attacked it with both guns blazing.

Some people derided the Fed's efforts as ineffective. That's because they were looking at how the stock market or housing market was reacting to Fed rate cuts. But the cuts were never meant to "solve" anything. Housing prices had to fall to more affordable levels. Nothing could (nor should have) been done to stop that. Stocks had to fall in reaction to the oncoming recession as well as the reality of a weak recovery. For that matter, unemployment was bound to rise as workers are moved from leverage-oriented jobs to someplace else. The Fed wasn't trying to solve any of these problems.

Compare this with Alan Greenspan's constant manipulation of the stock market. In today's FT, Greenspan says as much in an opinion piece. "In my experience, such episodes [rising or falling stock prices] are often not mere forecasts of future business activity, but major causes of it." (My emphasis). That sums up Greenspan's tenure at the Fed doesn't it? He's basically saying that by creating bubbles, he was able to spurn real economic activity. Look, a lot of us fell for it for a long time. He was called the Maestro for the Force's sake. But now, in hindsight, we can certainly see the folly in this philosophy.

Now the morons in congress are coming for Ben Bernanke for how he handled the Bank of America/Merrill Lynch merger. Seriously? Now, let there be no doubt. Ken Lewis was pressured by the Fed in a way that should leave a bad taste in the mouth of any free citizen. But we were in the middle of an economic war. Sometimes some bad shit happens on the battlefield and sometimes its OK if we look the other way.

If the Republicans push this, though, Obama will be left with little choice but to not reappoint him. Then we'll get Larry Summers. Great. Even if you forget all the virtues I've just bestowed on Bernanke, remember this. The key to an effective Central Bank is independence. Otherwise we have Arthur Burns. It was Burns, not oil, which caused the Great Inflation of the 1970's.

How can we seriously assume Summers will be independent of Rohm Emanuel? If Summers winds up running the Fed, mark my word, inflation will follow.

FOMC: Keep your concentration on the here and now where it belongs

So the FOMC follows Qui-Gon Jinn's advice and not Obiwan's instincts. Yesterday's FOMC release was a slightly hawkish shade of April's release, which I (and the bond market) found disappointing.

Just before the announcement, I suggested an alternate FOMC statement that emphasized both downside inflation risks (which the Fed dropped in their statement) as well as the need for an eventual exit strategy. I think my version walked the line between acknowledging the continued downside risks in the economy, the very tenuous and limited nature of the nascent recovery, as well as an admission that non-traditional monetary policy carries a risk of inflation. I've written time and time again that inflation is a low probability risk, but the severe steepness of the yield curve says otherwise.

The Fed would love to flatten the curve. That would bring down mortgage and other borrowing rates, and actually aide the recovery. The way to do that is to calm the inflation fears. No matter how much I might deride the hyperinflation story, it isn't going to magically go away. So if you are the Fed, why not assure the market that you are cognizant of this risks of quantitative easing? You don't have to give a time frame to the removal of accommodation, but you do have to convince us that it will eventually be removed.

FOMC: Be mindful of the future

Alright I'm trying something new here... I'm going to call the actual Fed statement. In about an hour you can make fun of how wrong I was.

---

Incoming data indicates to the Federal Open Market Committee that the economy continues to contract, though the pace of contraction appears to have further slowed since April. Household spending has shown signs of stabilization, but remains constrained by ongoing job losses and lower housing wealth. Credit conditions for both consumers and businesses have moderated, yet the Committee observes that credit is generally only available to the best borrowers in both markets. There are signs that the business inventory liquidation which occurred toward the end of 2008 and first few months of 2009 has ended, and some rebuilding of inventories may be underway.

Therefore while the Committee acknowledges the progress made thus far, it also judges that economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

In light of continued economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve currently plans to purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve currently expects to buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In addition, should economic conditions warrant, the Committee may choose to curtail these security purchase programs before the full amount has been purchased.

The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee believes these programs are temporary in nature and at some point in the future will need to be wound down. While it does not judge that the need will arise in the near term, the Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

---

The key changes:

• Indicate some improvement in the economic outlook, especially the credit markets, which have improved a good deal since April.
• Suggest that QE (outside of the TALF) will not be expanded. They won't come out and say so at this point, but given the improvement in the outlook, some curtailment of QE is appropriate.
• Acknowledge the need for an exit strategy. Conditions are too fluid to outline such a strategy right now, but its enough for the moment to discuss it conceptually.
• Finally, expect the FOMC members to start giving some specific ideas about an exit strategy in their upcoming speeches.

All this should calm the bond market, creating a bull flattener, and improve the dollar.

California Munis: What is it? Some kind of local trouble?

Lots of people have asked my take on California. Speaking strictly from a bond holder perspective, there are two issues. First, what are the possibilities for missed or delayed payments? Second, apart from actual missed payments, what could cause spreads to tighten or widen?

In terms of California bond holders actually missing a payment, those odds are remote. S&P points out in their report coinciding with putting CA on negative watch:

An austere analysis of the state's ultimate capacity, from a budgetary perspective, to service its debt suggests to us that at $35.97 billion, constitutionally required spending on education (Proposition 98 expenditures) for 2010 leaves $53.15 billion in resources available for debt service (estimated at $5.74 billion) on general obligation and lease revenue bonds.

So if it came down the state actually running out of cash, first certain education spending would be met, then bond holders. On that basis, there is plenty of coverage. I think this leaves the likelihood of a payment completely missed as extremely low.

Now a payment delayed is a different matter. If the legislature were to not pass a budget by June 30, the state wouldn't be able to sell short-term notes to restock their checking account. At that point, I really don't know what the protocol would be. If, in theory, the state literally ran out of money, they obviously couldn't forward coupon payments on to bond holders. This would be a form of default. But of course, bond holders would eventually get their payments, most likely when the next quarterly payments were made by tax payers.

We have to imagine what such a world would look like. You think Californians are pissed off now? Imagine the state is literally unable to make payroll. The political backlash would be severe. The fact that bond holders get cash first would put tremendous pressure on legislators, not the least of which would come from powerful public employees unions. So I imagine the most likely scenario is that some kind of budget is passed in the next few days.

Unfortunately, the odds also seem high that the budget will include some one-time revenue measures to help close the gap. As S&P noted, that's a problem, since it will likely mean the state will be in the same budget situation next year. Revenue items like sales tax might improve next year, but even in an optimistic economic scenario, unemployment will still be very high and property tax revenues will likely fall again. Its very hard to imagine how California's revenue would experience organic growth in 2010 or 2011.

If the budget is passed with significant stop-gap measures both the ratings agencies and bond holders will react negatively. I'd wager that right now players in CA GOs are unusually tilted toward speculators, hoping for a pop. A budget which doesn't address long-term problems will fail to create a pop, and most likely cause speculative players to sell.

What the legislature should do is create some mechanism for funding a reserve fund, even if the reserve won't be funded this year. For example, some kind of provision by which revenue flows into the reserve if revenue grows naturally by some percentage.

Ideally, there would also be work done on reforming CA's budget process. The combination of referendum-based spending with no attached revenue source is just silly. The corresponding need for super majorities to pass tax increases is similarly dumb. Its an obvious recipe for runaway spending without any reasonable means of funding the expenditures. A start would be to require all spending referendums to either have an explicit revenue tied to them, or to result in an automatic increase in sales tax. That would make voters think twice about voting an increase in stem cell research funding.

There is substantially more risk in local California credits, especially smaller school districts. One of the one-time measures the legislature is likely to use is borrowing/curtailing local aid. Combined with the fact that school districts take most of their funding from (gulp) property taxes... I think we're in trouble.

Black Swan: Fallen from the pure faith

This story in today's Wall Street Journey has me scratching my head. (I know, it was reported a couple weeks ago as well, I'm a busy blogger). I read Black Swan. I thought it was absolutely brilliant. Nassim Nicholas Taleb has truly come up with one of the most useful and original ideas about markets that I've read in my entire career.

All that being said, what I'm reading about Universa betting on inflation is total incongruous with what I thought was Taleb's philosophy: basically that the big events in life, history, and markets are almost totally unpredictable. Given this, the best way to invest is to bet on change. Not to bother with long-term predictions based on fundamentals as we see them today, because by the time the long term comes around, fundamentals will be wildly different.

Now I'll admit. I'm not convinced Taleb's method of investing (doing nothing but buying out of the money options) is a good trading strategy. But I am convinced that his general way of thinking is a critical addition to any trader's mindset. Don't assume that the world as we know it today will exist tomorrow. Don't assume that just because you can't think of a reason why the world will radically change, doesn't mean it won't. Just because you make an accurate prediction about a certain event, doesn't mean you'll be able to accurately predict the myriad of consequential events. Just because something seems impossible given what we currently know, doesn't mean its actually impossible.

Taleb and his colleagues have never been more vindicated than now, when what seemed like a backwater portion of the mortgage market (sub-prime) touched off a series of events that almost crashed the whole capitalist system. Even among those that saw sub-prime as a problem, few imagined how this crisis would play out. And that's was Taleb's whole point. Its nearly impossible to see the Black Swan coming.

So now... Mark Spitznagel, who runs Universa, the hedge fund Taleb advises, is betting on inflation? I'm not going to rehash my own view on inflation, that's not the point. The point is that Taleb is known specifically for not betting on markets and economic events. Any market/economic outcome that you can see ahead of time, even as a lesser possibility, it isn't a Black Swan at all. Many people see inflation accelerating. Almost every client meeting I attend, I get a question asking about the consequences of hyperinflation. I don't know that even an extreme version of a commonly held view can be called a Black Swan.

Second of all, Taleb and Spitznagel aren't economists. They are mathematicians and traders. I don't know that they are especially equipped to make an inflationary call.

So it makes you wonder. Is Spitznagel doing this because its his view of markets or his view of what's marketable? I have a feeling its more of the later than the former. He's brought in all kinds of new assets based on Universa's huge returns in 2008. Now he wants to continue the trend. He knows that hyperinflation is a common fear, and his fund is known for thriving during a period of disaster. Its an easy fit.

It just doesn't fit his purported philosophy. I remember an interview Taleb gave on CNBC during the winter when he derided the money bank executives had made, specifically arguing that they managed their banks to enrich themselves, not their shareholders... Mmmm...

Our methods are not as different as you pretend. I am but a shadowy reflection of you.

Fed: Deflation? Over my dead body.

Many Accrued Interest readers will gafaw at the memory of John Ryding, economist at Bear Stearns from 1991 until the bitter end in 2008. Intelligent man, I'm sure, but also something of the Nouriel Roubini of the bond market. I think he was bearish on interest rates basically my entire career, which is ironic, since for most of my career, interest rates have been falling.

Anyway, the one really good piece of advice I heard from Ryding over the years was if you have a view on inflation, don't change your inflation outlook, change your Fed outlook. In other words, if you think forces are aligning toward higher inflation, bet on Fed hikes, not on inflation itself. I think this is a smart way to approach the bond market, because the Fed may actually short-circuit inflation itself (making a bet on, say, TIPs a loser).

Today St. Louis Fed President James Bullard declared that the Fed had averted a deflationary outcome, and is now considering an exit strategy. As readers know, I've been touting deflation as the Fed's primary concern for some time now. But in talking about deflation as the primary risk, I'm still thinking of Ryding's advice. I'm not necessarily betting on deflation per se, but on a Fed ready and very willing to fight it. That's why I've been willing to bet on massive rate cuts, unorthodox liquidity programs, etc.

But will we see CPI print below zero? Only if the Fed fails. In other words, sustained deflation remains a remote possibility. But sustained Fed interference in the markets in attempt to avert deflation is a strong probability.

So the bet should be not on deflation outright, but on the fallout from attempts to fight it. Weaker dollar. Higher commodities. Low short-term rates (including buying 2-year bonds as opposed to holding cash). Flat yield curve. Lower mortgage rates (at least from here).

That's is how I'm playing my deflation view.

James Grant: Depends greatly on our own point of view

James Grant (of Grant's Interest Rate Observer) have a great interview on CNBC Wednesday, you can see it for yourself here. I'd say this interview represents the intelligent, pure monetarist argument for higher inflation. The type of thing that would have been perfect to pick apart on SMACKDOWN week!

For what its worth, I think Grant is a great writer and always an interesting read, though in recent years I think he's become more and more of a lawyer. That doesn't invalidate his argument, but it does tend to mean he seems less willing to consider possibilities away from his base view. I think its fair to say that Grant is generally against central bank intervention, particularly when it comes to stimulus. He comes from the school that thinks its necessary to keep money tight always and everywhere.

Here are a couple thoughts. First, Grant's off-handed comment that the Fed's balance sheet is as bad as Citigroup's is just dumb, and he's too smart to make that kind of comment. 54% of the Fed's balance sheet is in Treasuries and GSE debt. Another 14% is in straight currency and/or gold. 37% are short-term repo/discount window type transactions, which are all overcollateralized, mostly with extremely high quality collateral. 5% is in Bear Stearns/AIG bailout-related assets. That's the only realistic place where the Fed stands to lose money. Obviously Citigroup doesn't have such a high-quality list of assets. I said a few weeks ago that leverage alone isn't the sole determinant of risk. Is Grant trying to argue otherwise? Asset quality doesn't matter at all? Or is he just trying to throw a good sound byte out there?

He also comments that M2 is up 9% year-over-year, and that didn't happen back in the Depression. I can just imagine Ben Bernanke sitting at home throwing up his hands yelling at his TV. "EXACTLY!!" The idea is to prevent the Great Depression right?

He goes on to say that he expects higher CPI prints, but admits that its possible that the Fed's extra cash flows someplace besides consumer goods. That kind of thinking would be entirely consistent with my argument that consumer spending won't rise, and yet still suggest that the Fed's actions are problematic. In fact, I'd go so far as to agree that the cash must flow someplace. It is accurate to say that excess liquidity can and does lead to bubbles.

However, based on the data, I'd argue that the cash has all flowed into bank excess reserves. M2 is up $691 billion year-over-year. Excess reserves are up $836 billion. Is there a bubble in excess reserves?

I'd go on to say that once the cash starts to flow to consumers, they seem likely to save it. The savings rate is currently 5.7%. Household net debt has declined two quarters in a row now. If consumers see more money I'd think it would continue to flow this way. I don't think that printed money turning into balance sheet repair should worry us all that much. In fact, I think its a pretty favorable outcome, allowing consumers to improve their debt position without causing economy-wide deflation.

The risk, as similar to what I outlined last week, is that consumers become satisfied with a level of balance sheet repair, and funds start flowing elsewhere. In order to avoid this, the Fed is going to have to pull back on their extraordinary programs quickly, and frankly, soon. We'll see on June 24!

US Dollar: He's no Jedi

Some quick thoughts on the dollar. After the inflation SMACKDOWN from last week, especially my comments that I didn't see a dollar crisis and that foreign investors had few near-term choices but to accept Federation control er-- U.S. Treasuries for the time being, a lot of people are asking me about the dollar.

First a preface that I am not a currency trader, nor do I play one on the interweb. So its possible that the story I'm about to tell is baked in already, or that the dollar is already oversold and could actually rebound from here. But overall, it seems like the balance of factors lean toward a weaker dollar.

I'm a guy who appreciates the classics. Like early 80's sci fi, as you may or may not have heard. Anyway, I see currencies as a matter of relative investment return and relative inflation.

In terms of the big 4 currencies (dollar, yen, euro, pound), the BoJ is already stuck at maximum firepower in terms of monetary policy and the ECB is deluded about economic growth prospects. The U.S. has been much more aggressive in terms of easy money. The BoE is closer to the U.S. model, but still, less aggressive. So of the big 4, the U.S. has pursued the most inflationary path. Now as I've emphasized, I don't expect much in the way of actual inflation, but relative to the other currencies, we should have more inflation. That's dollar negative.

In terms of emerging currencies, I think the relative investment opportunities are greater abroad than here. While I expect the U.S. to keep its head above water, our economy needs to radically change. We haven't even gotten through the deleveraging process yet much less come up with new engines of growth! U.S. growth is going to be anemic for several years. Again, dollar negative.

I can't say what precise level of USD/EUR is right given this view, because like I said, I'm not a currency trader, and besides, I think my view is pretty mainstream. I don't see a crisis, but I also don't see a ton of upside for the dollar.

10-year Auction: This place can get a little rough

The 10-year auction was horrible. Non-fixed income people don't realize how big a miss 3bps is on a 10-year auction.

The ancillary stats indicate no foreign flee. Indirect bids were the second highest this year. So people will buy bonds, they just want more yield to do it.

Meanwhile, this story on Russia is worth watching. Can they really increase their IMF holdings, and if they do, does it matter? Here are two links to read.

http://www.imf.org/external/np/exr/facts/finfac.htm
http://www.imf.org/external/np/exr/facts/gabnab.htm

Russia currently holds about $140 billion in U.S. debt. I understand none of that is in Agency holdings so I assume that's overwhelmingly Treasuries. China holds $768 billion.

Its counter-intuitive to me that the DXY is solidly higher while Treasuries sell off. I really think this sell-off has reached silly levels.

Jefferson County: How many languages do you speak?

Apparently SMACKDOWN week was popular, as we haven't got a single vote against doing it again. We got a few Ooteedee votes, but those are either readers who are voting to continue with the constant obscure Star Wars references, or else those readers who speak exclusively Jawa. I wonder if anyone got the GONK reference on the previous poll... Anyway, e-mail me topic ideas, and I'll eventually post a list of the best ones for the readers to vote.

Meanwhile, I'm working on a piece on Jefferson County and I'd like to solicit some help from the readers. If you are a muni guy, especially a bond attorney, who knows the legal rationale as to why the County itself has taken responsibility for the sewer debt, please e-mail me. accruedint AT gmail.com.

Thanks, and thanks for reading.

SMACKDOWN WEEK: Epiloge: At that speed are you sure we'll be able to pull out in time?

So Accrued Interest has settled it once and for all. Inflation risk is low. The Poll proves it! I posted a new poll asking if readers like the SMACKDOWN format, where I spend several posts on the same subject in greater depth. If you liked it, vote. If you hated it, vote.

As a final point on the inflation subject, I wanted to look forward, to the future, the horizon. Obviously the dire consumer situation isn't going to last forever. Even though much of the wealth destruction I mentioned last week isn't going to recover in a V-shape, we will reach some sort of equilibrium in housing eventually. Even given a L-shaped recovery in housing, consumers eventually get back on their feet. Maybe they can't spend their home equity but they'll still spend their earnings. We will also reach some sort of equilibrium in personal savings, which I think will wind up in some relatively low, but still elevated level.

So inflation isn't dead. Not yet. And thus the Fed will eventually have to pull way back on its current policy accommodation. How and when will this happen, and what are the risks.

The biggest risk is Fed independence. You want to know what really worries me for the long-term? Fed independence.

I believe firmly that the men and women who are responsible for normal Fed policy actually learned the lessons of the 1970's. That inflation is an insidious problem, and once it takes hold, its is painful to wrench out of the system. I realize many readers will disagree, given the aggressive policy of the last 12 months, but spend a day going back and reading Ben Bernanke's old speeches, and I think you'll agree. Policy of the last 12-18 months has been all about eliminating a Great Depression style debt deflation. Once that battle is won, I believe the Fed's policy makers will want to wind down their non-traditional policy maneuvers.

There are those who say they can't remove these policies in a timely manner. I don't get this argument, as it seems to be merely based on the sheer size of the programs. Remember that inflation is a rate of change, therefore stock measures aren't terribly relevant. Its all about marginal changes.

To see what I mean, consider the Fed's MBS purchase program. As of June 3, the Fed had $428 billion in MBS on their books. To simplify, let's call that $428 billion in incremental demand in period 1. If they Fed just held their position, no new buys or sells, what's the inflationary impact in period 2? None right? No marginal demand for MBS from the Fed, no money printed. So execution of the exit is relatively easy.

To me its all about timing and will. The timing is a bit of a guessing game. I think we have seen some legitimate green shoots since January of this year. Consumer spending is way down, but no longer seems to be collapsing. Thus there should be some commensurate slowdown in the pace of the Fed's policy actions. Its also clear that the Treasury buying program has been a major failure, in that it spooked foreign investors. I expect the Fed to let the Treasury program die a quiet death, and let that be their first removal of some accommodation.

But do they have the will? There are those that say the Treasury has made the Fed its padawon. The Fed is creating inflation to help solve the Treasury's debt problem. I don't think this is the case, but its a scary thought. It would represent a return to Nixon-era central banking, where the Fed was highly political and thus unwilling to tackle inflation with the steady hand necessary.

Consider this. Will a Fed with an expanded mandate, as the primary regulator of banking and possibly other elements of the financial system, becomes more political? Probably. Will Congress get more oversight of the Fed-as-regulator? Certainly. Will that translate into less independence on the monetary policy side? Its a very big risk.

SMACKDOWN WEEK: Now consumers are all but extinct

Today on SMACKDOWN we'll look at just how inflationary the Fed's programs have been to date.

My premise remains that consumer inflation occurs because consumer spend more nominal dollars. I won't go over the rationale for this viewpoint right now, you can read it here or here. Given this, any program will only be seen as inflationary if it puts cash into consumer pockets, or at the very least, results in goods being purchased.

The headline grabbers are stories like this one at the New York Times. They throw out numbers like $12 trillion and we all cry out inflation! But a large percentage of these figures are asset guarantees, such as the money market insurance program. These programs are clearly not inflationary as they never even involved any exchange of cash.

In order to see how much money may actually go into the economy, let's take a real look at the Fed's balance sheet. We know it has exploded in size:



We also know that most of the Fed's outlays have been funded by crediting bank reserves. That is, the Bernanke's old "electronic printing press." If printing money makes you shudder, you aren't alone.

But remember, even printing money doesn't cause inflation unless that money reaches consumers. I've said before: if the Fed mints a quadrillion new Sacagaweas and just sticks them in a vault at Ft. Knox, there is no inflationary impact.

Alright so what's in the Fed's balance sheet? What have they buying with all that printed money? (All figures represent an increase).



I've color coded this based on inflationary impact. The various shades of blue are non-inflationary. Starting at the top and moving to the left, the first is the Maiden Lane transactions. These are all related to Bear Stearns and AIG bailouts (note I added some AIG-related loans that technically aren't part of Maiden Lane LLC into this figure). Can't see how these impact inflation in any meaningful way. The next is related to dollar swaps with foreign central banks. Again, while I think this helps provide meaningful liquidity to the worldwide financial system, the impact on consumer inflation is minimal, even if the Fed is "crediting reserves" to help provide the cash. Finally we have "other" Fed activity, which involves stuff like the Fed's gold stock. Not an issue.

Term Auction Debt and the CP/money market programs are a little more nebulous. These plus the actual discount window is in green. The Term debt is mostly the TAF and the TSLF, both of which were meant as quasi-discount window loans to banks and primary dealers. Neither is as heavily used as it was in late 2008. I'd argue that the these term loans are merely replacing other types of borrowing that would otherwise have occurred in the capital markets. So while it is interfering in markets, it isn't inflationary. The commercial paper program is similar. If it just replaces private sector borrowing, it isn't inflationary.

Now wait a minute, you say, the market is over-leveraged. This kind of short-term debt is what helped get us into this mess! The private sector should be winding down! The Fed shouldn't be encouraging short-term borrowing of this nature. That's besides the point when you are thinking about inflationary impact. Inflation (or deflation) is caused by the change in effective money supply from one period to the next. If all the debt was suddenly drained from the system, it would surely be severely deflationary. So to the extent the Fed is substituting its own balance sheet for private lending, that's a neutral event in terms of inflation. Indeed, according to the Fed, financial debt grew at a 6% pace last year, down from 12% in 2007 and the slowest pace since 1991.

The other programs (in yellow) do have some inflationary impact. Securities held directly are, most notably, the Fed's mortgage, agency, and Treasury buying programs. (I've subtracted the decline in repo from this figure, since these new programs really replace the Fed's old repo-based programs.) When the Fed buys bonds, they are buying them from someone, and that cash eventually makes it into the system. I've argued that in fact, securities purchases are just a convenient means of pumping dollars into the economy. So it seems that an inflationary result is the goal.

Same with the TALF. The idea behind the TALF is to restart the ABS markets, which would provide cash directly for credit-based consumption. This is practically printing money and giving it to consumers. However, for better or worse, the TALF has been little used. It was supposed to be up to $1 trillion. It would be just as well to let him go, he's too far out of range.

Now let's add up the "inflationary" increase in the Fed's balance sheet. $528 billion.

Now let's compare that with some other key indicators of consumer behavior. The chart below compares the increase in the Fed's programs with the decrease in the other indicators. The decreasing elements have been inversed to illustrate the relative size.



The amount of inflationary Fed programs is slightly larger (in the scheme of the overall economy) than the decline in nominal GDP, consumer debt, and consumer spending. Now none of these figures are directly comparable, i.e., you can't say the inflationary impact is simply x - y. But comparing the relative size of each of these gives some sense of context.

Now if we add the decline in household assets...



Suddenly the Fed's activity seems like a drop in the bucket. And that figure is only through 12/31/08. We don't yet have the Fed's Flow of Funds report through 1Q. We know that household assets are continuing to decline, as evidenced by the continued drop in home prices.

Now we know that eventually consumers will regain their footing and start to spend (and borrow) again. So even if you agree that the Fed's actions aren't inflationary for now, they may become inflationary once the economy starts recovering. So its all about the exit strategy. That will be next time, on SMACKDOWN!

SMACKDOWN WEEK: China: If you leave now...

Thanks to the readers for all the e-mails so far. Most have concentrated on the problem of foreign ownership of U.S. debt, and the potential impact on the dollar should foreigners stop funding our profligate spending.

First, let's make a distinction between debt monetization and what the Fed is currently doing with their Treasury buying program. A classic debt monetization is a solution to overwhelming domestic debt. Its printing money to actually pay off the debt because the government has no other solutions. If you want to claim that the Treasury might someday get to this point, have at it. But its clear that in the here and now, the Fed's buying program isn't meant to solve the problem of deficit spending. The Fed wants to buy Treasury bonds in an attempt to put more money into the U.S. economy in the name of fighting deflation. It might also be an attempt to force interest rates lower, although I'm increasingly doubtful that is their intention. Either way, Treasuries are just serving as the helicopter out of which the Fed is throwing money. In other words, Treasuries are a means to an end. In a monetization, buying Treasuries is an end of itself.

That being said, its legitimate for foreign investors to fear the possibility of a monetization. I can't say its out of the realm of possibility, and if your China, it would be such a disaster, they have to be watching it.

Right now, I think the U.S. and China are living in a state of mutually assured destruction. China has too much invested in U.S. dollars, and thus can't afford to have it tank. Meanwhile the U.S. has borrowed too much from China. We can't afford to have the Chinese exit.

Therefore thinking about Chinese exit is a bit like thinking about a nuclear attack during the cold war. Can't deny the possibility, but it wouldn't be in anyone's interest to allow it to happen.

How worried are foreign investors? So far they are mostly just talking. Here is the bid/cover ratio on recent 2yr, 5yr, and 10yr auctions. If the Treasury is auctioning $20 billion and the bid/cover is 2, that means they they got $40 billion in total bids.



No obvious pattern here. Plenty of buyers for Treasuries. For me, I don't take much from any given bid/cover, because a bid at any price counts. I.e., if you bid 4% for the new 10-year, that counts as a bid, even if that's actually 40bps away from where the 10-year is. But as long as the bid/cover is solidly above 1, we aren't in danger of a failed auction.

Another worthwhile auction stat to watch is indirect bidders, where foreign central banks normally hide out.



No real pattern here either.

TIC data measures foreign buying directly, but its always a little dated. Anyway, here is net purchases (buys minus sales) of Treasuries. The red line is a 12-month rolling average.



Again, no obvious pattern of selling. Now if you want to see what foreign panic looks like, check out the chart on Agencies.



The Jutland Wastes are not to traveled lightly! I've heard the Russians blew out all their Agency positions entirely, but I've also heard Chinese insurers say they'd be a natural buyer of GSE debt if it were indeed full faith and credit. Part of this too reflects an overall decline in Agency issuance, but let there be no doubt, foreigners panicked after FN/FRE conservatorship.

The overall TIC does show some pattern of decline...



But it appears to reflect a change in risk tolerance. Since overall TIC is declining while Treasury purchases are about flat, it means that foreign portfolios are more heavily Treasury weighted than in the past.

I've said before that the dollar won't have the same dominance as a reserve currency in 25 years. But I be surprised if the impact is felt in any given year. The big foreign bond buyers have come face to face with a dollar disaster. Just because it didn't happen doesn't mean it won't result in changes. But they will be long-term changes. The kind that are hard to trade on.

To those who really fear a China sell-off, my challenge is to show me hard evidence that its happening.

SMACKDOWN WEEK: Prequel

Later today I'll post my first extended rebuttal to the inflation argument, specifically on the concept of debt monetization and foreign participation in the U.S. Treasury market. There's still time to write me your thoughts (accruedint AT gmail.com)!


Meanwhile, I've posted a poll on where you come out on the inflation/deflation case. See the right hand side of the main page.

Also, as a bit of a prequel, I thought I'd post a link to my primary deflation argument from a few weeks ago. Feel free to post your own rebuttals here, or if you make a rebuttal on another blog, post a link in the comments.

Treasury Market: Gonk!

John Maynard Keynes once famously said "The market can remain irrational longer than you can remain solvent."

Now, I believe in a generally efficient market, but not the one you read about in college. The textbook theory of efficient markets describes a world were security prices constantly move toward "real" value. Where information is instantly disseminated, asset, and priced into security valuation.

In real life, the "correct" assessment of information isn't so black and white. Especially since in real life, economic data is often pointing in multiple directions at the same time. Market participants must then weight various bits of data to make a valuation determination. Some will put more weight on certain pieces of data, while others will overweight other items.


This is starkly evident in the U.S. Treasury market right now. I've argued that inflation is of little concern here, despite some improvement in the economy. I point to data like today's release of Personal Income and Spending. It shows that consumers have more income to spend for the first time in 7 months. But they aren't actually spending that income: Expenditures declined by 0.1%. I've said it before and I'll say it again, there is no consumer inflation without consumers spending more money in nominal terms. Deflation is the bigger worry when consumer spending is declining.


Others take the other side, arguing that massive government deficits and the ever-running Fed printing presses will cause inflation. The dollar and foreign willingness to own U.S. Treasuries also plays into the bearish Treasury view.


The difference of opinion is especially wide now. The inflation camp suggests 10-year Treasurys rise to 6-7% or even higher. The deflation crowd currently sees a 10-year Treasury yield which is currently above typical real yield. The median real 10-year yield (just taking 10yrs minus CPI) is about 2.9% since 1989. If I assume inflation will print at or near zero in the coming months, then Treasuries seem like a deal at 3.70%. Obviously if you foresee inflation accelerating to anything above average, even something as benign as 4%, Treasury yields are far too low.

No near-term event is really going to resolve the debate either way. The economy has improved substantially since last fall, when I was writing most about deflation. Despite this, I still see a consumer preoccupied with balance sheet repair than buying new dishwashers. The inflation crowd is the same way. When the dollar was stronger earlier in the year, I didn't see the inflation crowd backing off, and why should they? Their basic thesis was still in tact.

The perception of the debate is colored day by day based on where the market is going. Friday the Treasury market was up substantially and I got a few e-mails congratulating me on my recent buy. I responded (and I blogged) that I thought it was just a month-end extension, not a validation of my view. Lo and behold, the rates market gets crushed today.

In fact, I argue that an argument always sounds smarter when its backed up by recent market moves. I can't tell you how often investment managers and traders come on CNBC and make an "argument" for a certain position that doesn't contain any argument at all. For example, if one went on CNBC and said "I think the long bond is going to 8% because inflation will spike, the Asians will dump Treasuries, and the deficit will get out of control." That's not really an argument is it? Its just a statement of cause and effect. We know Treasuries will get crushed if those things happen. The question is why might those things happen. Right? That argument is like a detective pronouncing a case closed after determining that the victim was shot. Who shot the victim is the real question.

Anyway, if you make the Treasury bear case on a day when Treasuries are getting crushed, the human mind instinctively find your argument more compelling. This guy says the Treasury market is going to get crushed, and look at it! Its already happening! If you watch, you'll notice that on any given day, CNBC tends to have more interviews with people who agree with that day's market action than not. Can't be a coincidence. It makes the casual observer feel like CNBC has on smart people!

What makes this all tough for the serious analyst is that you have to balance holding firm to your viewpoint while admitting you could be wrong. Its another way of saying that the toughest thing in investing is a sell discipline. I'm long Treasuries now (only avoided a real shellacking based on some good technical analysis). I believe in my deflation thesis, but I know I could be wrong. The inflation camp isn't stupid. There is a valid argument for much higher interest rates. The smart trader puts his ego aside and admits when he's wrong.

Many have e-mailed me asking for signposts that I'm wrong. I know what my signposts are, but I'd rather put it back on the readers. E-mail me (accruedint AT gmail.com) with the best arguments you have (could be your own, another blogger, a research report, etc.) for a significant Treasury sell-off. I read a lot of arguments myself, of course, but I won't pretend that I read everything. Send me the best stuff you have. Over the course of this week, I'll respond point by point to some of the best pieces I get. While I'm making my points, I'll also try to show the indicators I'm watching that would tell me that I'm wrong and the opposing writer is right. We'll call it Deflation vs. Inflation week! Its a smackdown!