Issue 11: Square One, Revisited?

Square One, Revisited?

Courtesy of the New York Fed's public website, I present the daily effective Fed funds rate from August 8 (immediately preceding early August's epic volatility spike) up to this past Friday, inclusive, to which I have added a column of daily stock market volatilities. (Red indicates a substantial increase in volatility from the preceding day, or remaining at an extremely high level of volatility.)

From the chart, you can track why the market expected the Fed to cut its key funds rate by either 25 or 50 basis points, and as August neared a close, expectations shifted to center on a 25-bp cut.

Hopefully thanks to my alarmist red You can also see a fairly strong recent correlation between sharp spikes in standard deviation of effective Fed funds, and subsequent spikes in volatility. (Large spikes in volatility are overwhelmingly associated with losses in equity markets.)

In normal times, the Fed can easily keep the daily effective funds rate (the “DAILY” column) to within five basis points of its target rate. Obviously, it was not able to do so on August 9-15. That was the catalyst for early August's seismic increase in volatility to levels not seen since mid-2002. On the days in which the effective rate diverged dramatically from the target rate, standard deviation was also extremely high by historical norms (usually less than 10 basis points). So anybody who has seen the last two days of standard deviation of the effective rate has good reason to be worried.

Additionally, although volatility has gone down significantly in the past two weeks, yields on three-month Treasury notes plunged from 4.63 percent to 3.84 percent during August 27-30. Investors have continued subscribing to T-bills in massive amounts even after volatility apparently ebbed. Rates for three-month T-bills, which traded at a daily weighted average of 4.95 percent on August 13, plunged over the next week to 3.12 percent on August 20. On August 30, they traded at 3.84 percent – much improved from 3.12 percent, but still very low, and much lower than the 4.5 percent or so at which they traded in the first half of August.

What is of greater concern to me, however, is how the markets have jumped so eagerly over the past two days at virtually any piece of good news. E.g.: Bernanke gives a typical “On the one hand, ... on the other hand” Fed speech, saying that if things get really bad, the Fed will help out, otherwise it won't. Nothing new there; but the market jumped anyway. Then President Bush comes out with a “mortgage assistance plan” which is, at best, cosmetic; the market jumps some more. (Both of these announcements were made last Friday.)

The tenor of the central bankers at Jackson Hole, Wyoming, was decidedly more pessimistic. With some notable exceptions, the generally demanded that Bernanke cut the Fed funds rate to avert “this very bad outcome” of a momentary recession. Essentially, the (very large) mortgage and banking industries want a bailout. (Apparently, “capitalism” that entails punishment of mistakes, alongside rewards for success, has become decidedly old-fashioned, at least as far as rich financiers are concerned.)

I don't profess total knowledge of economic conventional wisdom, but one piece I do know is this: “There's no such thing as a free lunch.” The Fed can alter the distribution of recessionary economic events over time – at a significant price – but in the long run , the Fed cannot stop recessionary activity from happening. The Fed controls money, not output, and the Fed's money (the dollar) would over time lose value faster than the Fed tried to manipulate output via inflation relative to other global central banks. Which, come to think of it, would be a very succinct way to describe the last four years of Greenspan's Fed tenure.

After the 9/11 attacks, there was a good argument to be made for a mildly inflationary monetary policy. On 9/11, equities markets were in the midst of a massive recession, the United States suddenly had at least one global war to fight, and there was a very good argument to be made for transferring the dotcom bubble into real estate, in order to keep a looming economic crisis and the geopolitical, global-insecurity crisis from feeding off each other and inflicting much broader economic damage. Better to push the economic problem back several years while the geopolitical crisis resolved itself; a larger recession several years down the road was a worthwhile price to pay for altering the distribution of negative marginal economic information.

On the happy side, 99.9% of Americans roll their eyes and/or think of Stephen “My pants are at threat level brown” Colbert every time they hear “threat level orange” at the airport. The geopolitical crisis has resolved itself in terms of relevance to Americans' economic activity. Unfortunately, the recession Greenspan put off several years down the road is back for seconds.

Even with the severe problems in the asset-backed securities, mortgage-backed securities and commercial-paper markets, Bernanke is still accountable for a very weak dollar. He knows that the legions of “financial insurance” hedge funds – hedge funds that essentially promise below-average returns most of the time, and huge returns during volatility spikes such as we just experienced – have plenty of money, as do the more conventional funds that made the right contrarian bets (Citadel, Ellington, Balestra, etc.) several months before FUBAR unfolded. However, these funds are waiting, because they think fundamentals justify more bloodletting, and regardless, they don't want to do anything dramatic until they have a better read on Bernanke.

Additionally, not only is the LBO boom dead and buried, but the investment banks are still sitting on a quarter trillion dollars or so of unsyndicated debt for LBOs that they signed onto, but effectively can no longer finance. It was so bad, in fact, that the banks charged with syndicating the $45 billion private-equity buyout of TXU offered to pay Kohlberg Kravis Roberts $1 billion to get out of the deal. One thing that does not tell me is that “the worst is over.”

On a final, less-bearish note: Yves Smith of the Naked Capitalism blog (near the top of my daily required-reading list) noted that there have been many instances in which substantial contractions in real estate valuations did not lead to epic recessions. The banker-bailout caucus at Jackson Hole seemed to be taking the Great Depression as the only relevant example of a real estate recession's disastrous impact on the broader economy, but many western nations have endured short (if sharp) recessions after double-digit real-estate contractions, and gone on to live another day (including the US of A). Such is the case here, in my opinion.

The Bottom Line

All my forecasts from the past week hold. (I was happy to see gold appreciate by one percent on Friday, two days after I said gold's price was misbehaving.) Fundamentally, we haven't seen a bottom yet.

If Bernanke holds firm in terms of monetary policy, gold will lose less value than other asset classes; if he bows to the bailout caucus, gold will go on an inflationary tear. Long gold, long cash .

Other asset classes long: Euro; blue-chip tech stocks (Google, eBay, Yahoo!, etc.)

Neutral: USD

Short: Commodities, Eastern European currencies ex-Poland, commodity currencies (CAD, AUD, ruble, Saudi riyal)

Long-short pair: Long one unit Credit Suisse per one unit short of all other financials

--Alex Forshaw
  Editor in Chief

  http://www.bestwaytoinvest.com

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