This Fed Is One for Turning
A “bold cut,” slavered the Economist. Not to be out-cooed, the Financial Times enthused that Bernanke “acts boldly” and “moved aggressively to head off the risk” of a recession . The Fed surprised the market; stocks soared; and economedia had their big bullish story and big green arrow to splash on the front pages. I have little basis, but less doubt, in believing the Wall Street Journal will be similarly shocked and awed.
Yet somehow, the Fed's act seemed more shopworn than usual.
Ironically, I was informed about three hours before the Fed went 25 basis points too wobbly that at the Jackson Hole masters-of-the-financial-universe powwow on August 25, there was a quiet but powerful undercurrent of sentiment among attendees that core CPI, the Fed's standard inflation metric, was relatively useless, on the grounds that while everything stripped out of the “core” - food, energy, etc. - might be highly volatile, in the past two years those factors had collectively exhibited purely upward volatility. If that argument sounds familiar, it should (“inflation ex-inflation”), because I practically typed myself hoarse making the same point in this newsletter's youngest days.
The newsletter is pleased that its most consistent call – “buy gold” – has performed spectacularly, abetted by the Fed's bad call. As we noted last week,
Unfortunately, the Fed is one of the most politicized central banks in the world, and if enough policymakers start making threats, the Fed will be forced to cave. Bernanke's recent assurances that he will “act as needed” (with Senate Banking Committee Chairman Chris Dodd close at hand) have thus far been purely show.
If Bernanke caves (and there is a significant but indeterminate probability that he will) gold will gain very significantly. If he does not, gold will lose less value than most other assets. Therefore, gold remains a solid bet.
Judging by the tone of longtime Fed stenographer John Berry, Bernanke had decided, as of two Fridays ago, on a 25-bp cut. In the following days, some very significant things happened: American data were generally very weak, the Fed's decreasingly credible core CPI numbers were very tame, and the British banking system came very close to a full-blown bank run.
Over the weekend, Northern Rock, a middle-market British bank that used huge amounts of mortgages as collateral for loans, very nearly went bankrupt. As mortgage-backed securities markets froze up and hemorrhaged value, Northern Rock was effectively bailed out by the Bank of England (which incidentally shattered the BoE's monetary credibility) because UK Prime Minister Gordon Brown does not want any bank defaults to tarnish his previously-watertight election campaign. British depositors, however, were extremely alarmed by the Northern Rock quasi-bailout, and reacted by withdrawing billions of pounds in savings which would be at risk if NR blew up. Lines stretched for blocks outside NR branches, and there were even isolated instances of couples barricading themselves inside NR branches (whose “service” slowed to a crawl) to get their money back. It was all very 1930's, and panic was beginning to spread to another middling bank with a huge MBS book, Alliance & Leicester. However, Anglo capitalism has always held that in all but the most extraordinary circumstances, companies must be allowed to fail regardless of size.
At the end of the day, though, NR went very long liquidity in the MBS market to expand rapidly. That was a bad bet, and Gordon Brown – known for making a jaw-droppingly stupid bet himself as Chancellor of the Exchequer by selling billions in Exchequer gold at the bottom of the gold market – forced UK taxpayers to pay the price of that bet. Had UK withdrawals accelerated after the second bailout, the game would have been up.
There was little evidence, however, that the UK problem would have spread to the States even if the UK had done nothing to bail it out. Furthermore, the dollar is at a historical low, gold is at a 15-year inflation-adjusted high, and virtually every other market-based inflation indicator is flashing red. Even if inflation has begun to moderate slightly as economic activity has slowed, it's still pretty clear that the Fed has been lowballing inflation for years.
Lehman's Bluff
Because I don't consider myself to be as smart as Bernanke or Hank Paulson, I think Paulson in particular believes that there is much more bad debt in American banking institutions than meets the eye. (Paulson was the former CEO of Goldman Sachs, the most aggressively speculative of the American investment banks.)
Lehman Brothers was the first investment bank to report third-quarter earnings. Their reported numbers came in significantly ahead of analysts' expectations, but I'm not sure anybody was “surprised.” The quiet consensus seems to be much closer to, “Ah, so they went ahead and bluffed.”
Eight percent of Lehman's assets are classified as “Level 3.” Considering that a majority of Lehman's assets are classified as “Level 2,” or “mark-to-[maybe-functional] model,” and Level 1 seems to be pretty standard liquid assets, “Level 3” apparently means something along the lines of “mark to whatever the hell we want.” In my humble opinion, eight percent of Lehman's book has about as much value as the Bear Stearns Structured High Yield Enhanced Leverage fund; that is to say, the value that a counterparty would be willing to pay for a Level 3 asset, or five to fifteen cents on the dollar. I guess that would have cropped bonuses a little too much.
The banks are very powerful, and the rules and markets so arcane, that Lehman (along the other banks engaging in Level 3 chicanery, i.e. Bear, Goldman and others) probably won't be called out on (what seems to be) blatant Enron accounting. The banks' strategy seems to be to hold on, hope for some new sparks of life from the market, and liquidate what they can in a more favorable market climate. Personally, I think it's extremely dubious that they will succeed. I think the major banks will drift along like bleeding whales until a very large hedge fund launches a speculative attack on the financial sector or a major central bank throws enough dynamite in the water (in the form of stringent interest rates) until at least one dead whale surfaces. In the meantime, I expect equities to perform similarly to the very early 2000's, when they jumped like rabbits at rate cuts, and lost those gains in relatively short order as economic fundamentals continued to deteriorate.
Recommendations & Outlook
I had shifted to neutral on the GBP earlier for technical reasons; the GBP has done impossibly well already, thanks in no small part to the hard monetary line set by Mervyn King. Last weekend, the perceived toughness and political independence of the Bank of England was drawn and quartered by Gordon Brown. Additionally, the UK economy has experienced an even more feverish financial and real-estate boom than New York City did. It's over, and suddenly the UK doesn't seem so much the prospective capital magnet anymore. Sell GBP .
With Bernanke and Gordon Brown having resolved to shred their respective financial credibility as rapidly as possible, the ECB's hawkishness and reticence stand out. They have not, to my knowledge, actually bailed out a bank yet (they merely injected huge amounts of repos, or very short-term loans at market interest rates, into European money markets, although some small banks were bailed out by local governments).
Furthermore, the dollar's status as the global reserve currency has been slipping for some time. Interest-rate differentials have shifted decisively against the dollar, and even if the ECB does shadow the Fed's rate cuts, the perception will be that it will do so somewhat reluctantly, and investors will impute more hawkishness, and higher future value, in the euro relative to the dollar. Buy Euros, sell USD .
With more dollar depreciation, gold will continue to appreciate. As I never tire of saying, gold has both inflationary and deflationary upside (in the sense that when most assets lose value, gold tends to lose value at a slower rate). Also, keep in mind that in current dollars, gold peaked at approximately $2,100/oz in 1980 (contrary to misleading headlines proclaiming that gold is at a “27-year high,” which is true only in nominal, inflation-unadjusted, and thus useless terms). The current price of gold is well above its secular average, but it is not extreme in any sense. Buy gold .
The “natural resource currencies” – AUD, CAD, Mideastern currencies, the ruble – are trickier. As long as the Fed deludes itself as being “ahead of the curve” in feeding the economy's addiction to cheap debt, oil will not go down, so neither will most of the oil currencies.
However, while price elasticity of oil means that oil soars during economic booms, it also reflexively drops faster than anyone expects during slowdowns. When that happens, the oil currencies will march in lockstep off that cliff. Unfortunately, I already erred in one Fed forecast. I would recommend selling oil and oil stock, but only to the most risk-lusting specuvestor.
The JPY is as unpredictable as ever. No JPY recommendation .
I hope you enjoyed this week's newsletter. Please send any comments or questions to my e-mail address at alex.forshaw@gmail.com .
Best wishes,
Alex Forshaw
Editor in Chief
http://www.bestwaytoinvest.com
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