The 'Fix' Is In

By: Michael Ashton | Sun, Nov 20, 2011
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Economic data last week was not discouraging. If you want to look backward for comfort, the Retail Sales data was a little stronger-than-expected, along with Empire Manufacturing and Industrial Production. Initial Claims retreated to the lowest level since April, at 388k. None of these numbers blew the doors off of predictions, but they were all shaded positively. The chart of the Citibank "economic surprise" index, below, shows that "good" surprises have finally started meaningfully outweighing "bad" surprises for the first time since, again, late March or early April.

Domestic economic data have been pleasantly surprising lately.

The inflation data, too, was good news, although as I said on the radio last Wednesday the slowing of core inflation these last two months was overdue and should not be taken as an 'all clear' signal.

This is all encouraging news. The United States is not in recession at the moment and, left to itself, would appear to be on a track to improve (although far too feebly for anyone's taste) in the immediate future. Unfortunately, the U.S. is not being left to itself. Far from it, and the conditions in Europe continue to deteriorate alarmingly.

Both Spanish and Italian 10-year yields are in the 6.25%-6.50% range. Italian bond yields are only that low because of ECB buying last week. Over the weekend, Spain ousted its ruling party. As with Italy, there will be some cheerful interpretations of this as good news since the new government may be able to implement the "needed fiscal reforms," but in Spain's case the existing damage to the cajas probably puts the country's situation beyond ultimate repair.

We are moving seemingly inexorably to a resolution in which the Euro either dismembers, disintegrates, or draws even closer together. For all of the talk, I can't imagine that more integration is something that the populace will accept in the middle of a crisis. The view of such plans will be something like "the Titanic is going down! Let's all hold hands on the deck and everything will be okay." I believe the choices are dismemberment - letting (or forcing) weak members to leave while preserving a strong-ish core - or disintegration. Secondary and tertiary choices will affect how controlled or how uncontrolled that conclusion is. The signs there are not great, as the political bodies in Europe seem unable to choose the stitch in time that might sav e nine. Although I suppose I ought to also add that the Union's changing tone towards Greece, in what looks like triage to me, has the aroma of a fairly grown-up decision.

As the markets slide into ever-less-liquid conditions, this is starting to come to a head. And this isn't the only thing we will have to deal with over the final five or six weeks of the year. The U.S. "supercommittee" seems unlikely to agree to any meaningful deficit reduction arrangements before the deadline on the 23rd. Now, few people really expected them to do so, but it is an unhelpful reminder of how dysfunctional our political system has become, where increasing deficits is trivially easy and decreasing deficits is almost impossible. Add to this the escalation of anti-Iran rhetoric coming from Israel, that could well come to a hea d in a week, or not for six months.

To say that we are in a dangerous period is cliché by now. But the fact that we are in this state while liquidity conditions are set to get much worse over the next few weeks makes the danger acute.

Since the beginning of August, the S&P has been in a range from 1100 to 1300, and after exploring both sides of that range finds itself almost smack in the middle. This should be a stable position to be in, and it surely beats being at 1100 or 1300 since there will be plenty of investors with views as the market moves to one or the other extreme. I suspect we will see lower prices into the end of the year. In a normal year, starting from 1200 in a 1100-1300 range would mean the extremes of the range were likely secure. I don't get that feeling this year, with this backdrop and the illiquidity that we are going to see (made even worse by the stressed conditions of European counterparties).

But don't get complacent and think that longer-term Treasuries are safe. With the 10-year yield at 2%, in the middle of a 1.70%-2.40% range that has prevailed since mid-August, the same caveat applies. Investors who need safety will hold short-dated Treasuries, but that might also include some current holders of long-dated Treasuries. Twist or not, I don't care for Treasuries at 2% when the bond vigilantes are riding. Greece, Italy, Spain...can Japan be far behind? And the U.S. is not sacred.

What will monetary policymakers do? In a word, they will pursue every simulative action you have ever seen. Some will buy sovereign bonds. Some will buy mortgage bonds. Some will simply sell unlimited amounts of their own currency (such at the SNB). The forex markets will continue to be choppy and I think hard to trade.

Let's turn back to the U.S. a little bit, and talk about the probable and possible actions of the Federal Reserve. And again, let me look backwards and note some soothing data. The chart below shows 52-week commercial bank credit growth. While the absolute level of commercial bank credit is still 5.5% below the all-time highs of 2008, and a 2% year-on-year rate of growth is still pretty feeble, it ispositive and the trend is upward.

Yay! Commercial Bank Credit is up almost 2% over the last year!

Is this good news or bad news? Well, it is certainly good news that banks are lending, although the fact that M2 money supply is still expanding at a 10% rate over the last 52 weeks is probably not unrelated to this fact and that creates a clear inflationary possibility. The bad news is that the Fed's actions are most likely slowing down this process.

The Federal Reserve has added copious amounts of liquidity over the last few years, which as has been well documented has flowed into reserves rather than into loans and M2. That liquidity has been stuck in reserves for two reasons. One is that the Fed is providing an incentive for banks to hold excess reserves, by paying them to do so. The other, which I have not previously mentioned, is that the Fed is providing a disincentive to lending by holding interest rates abnormally low. And the reason why is really Econ 101.

There is no question that loan volumes have been poor. Bullish analysts claim this is because no one wants to borrow money; analysts who actually have spoken to borrowers and lenders know that many borrowers (especially underwater mortgagees and small business owners) want very much to borrow at these low rates, but cannot, and understand that the low loan volumes are due mainly to the fact that standards have changed sharply for lending. The bullish analysts will point to charts like the one below, which shows that the net percentage of domestic respondents reporting tightening standards for commercial and industrial (C&I) loans for large and medium firms has been negative for eight quarters. That is, banks have been responding to the Fed's Senior Loan Officer Survey by saying that they have on balance been easing sta ndards slightly.

Sure, slightly more Senior Loan Officers report easing standards then tightening,
but by how much?

However, the survey doesn't measure by how much the standards tightened back in 2007-2009 compared to the amount they have loosened recently. For example, if banks had previously been willing to lend money on an unsecured basis in 2006, and by 2009 were requiring 140% collateral coverage of the loan, and then gradually loosened standards so that they now require only 100% coverage, conditions would obviously be much tighter now than they were in 2006 and still quite tight...and yet, going from 140% to 135% to 130% to 125% would result in three quarters of "easing standards."

We can have some idea this is happening by looking at mortgage loans. The Fed's Operation Twist was supposedly motivated partly by a desire to lower long rates further so that more consumers could refinance their mortgages. But refi volumes haven't responded to Twist from the levels they were already at, and the overall level of refinancing (the Mortgage Bankers' Association Refi index is shown below) remains below levels seen in late 2008, mid-2009, and late 2010.

MBA Refi Index. Operation Twist hasn't done a lot yet -
refis were already modestly above the baseline.

Banks are still not lending aggressively at record low rates. And why would they? Given the choice between being paid something for holding risk-free excess reserves or being paid slightly more for extending a ten-year, risky loan, is it so hard to understand why the lending hasn't happened? Moreover, it makes perfect sense: when you place a ceiling on the price of something...say, interest rates...then you tend to have a shortage as the chart below illustrates. At a price of "a," "b" units of credit are supplied and "c" units are demanded, so there is a shortage of c-b. Right now, there appears to be a shortage of credit available to borrowers at the price the Fed has "fixed."

Econ 101 depiction of the supply and demand of a product.

The supply of credit, in other words, is not exogenous. The Fed is treating the amount of credit available as being determined independently from its price, which the central bank is endeavoring to keep low in order to stimulate the economy. The demand for credit and the supply of credit are both functions of price, of course.

Does that mean that the Fed should let long rates rise? If the Committee's goal is to increase credit availability (it isn't entirely clear that this is their goal, or that it should be given that the economy is busy recovering from a contraction of credit), then letting rates rise might allow the market to clear at larger credit volumes.


On Monday, the Chicago Fed Index (Consensus: 0.19 from -0.22) is due to be released at 8:30ET and Existing Home Sales (Consensus: 4.80mm vs 4.91mm last) will be out at 10:00ET. These numbers will probably be largely ignored as most other domestic data has been recently, as investors continue to digest doings in Europe.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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