In our assessment, the Federal Reserve's (Fed's) interest rate cut was wrong. Forget about the "moral hazard" of whether the cut would plant the seeds for further bubbles. Lowering interest rates is wrong because it will do few any good, but cause many a lot of harm.
As the most imminent result, the U.S. dollar has accelerated its decline versus hard currencies. When a country's central bank cuts interest rates, it is rare that the currency reacts in textbook fashion and declines more than a token amount versus other currencies; that's because, amongst others, lower interest rates may boost growth and make the currency more attractive for investments. Not so this time with the Fed's cut: lower interest rates are unlikely to boost economic growth. The reason? The markets are facing a valuation problem, not a liquidity problem.
Will a subprime borrower be helped by the cut in interest rates? Will his or her adjustable rate mortgage that is about to reset to a much higher rate suddenly become affordable? Will mortgage derivatives suddenly become tradable? Or will these illiquid derivatives be accepted as collateral once again for speculators to borrow money? We believe the answer is a clear NO because the problems are prices, not access to money. To heal the excesses of the housing bubble, we need lower home prices; subprime borrowers are best helped by downsizing, not by receiving subsidies (see also "If you want a subprime bailout, do it properly"). There is no shortage of consumers to borrow; there is a shortage of lenders to lend. Conversely, there is plenty of cash around; it's just that those who have cash are not willing to pay the prices demanded.
The Fed's grave mistake was to lose control of money supply during the credit driven expansion (please see our February 2007 analysis "How the Fed lost control of money supply"). As volatility, risk and fear are returning to and are priced back into markets, we are facing a market-induced credit contraction. As investors pare down their leverage and demand higher yields to be compensated for risk, the Fed is nothing but a small, and in this case almost irrelevant, participant in the markets. It's in this context that former Federal Reserve Chairman Greenspan is correct when he laments in his memoirs that central banking is becoming less important.
The markets are facing a major challenge, though, if acting central bankers, including Fed Chairman Ben Bernanke, believe they are stronger than the markets. Pushing liquidity at any cost when the markets demand a contraction is what gold bugs have been waiting for; that's a positive way of saying Bernanke may live up to his "Helicopter Ben" reputation, flood the market with fiat money and risk further destroying the purchasing power of the U.S. dollar.
The problem gets more severe as many U.S. policy makers believe a weak dollar may actually be good for Americans. Bernanke, in his academic work before becoming Fed Chairman, has expressed that had the U.S. veered away from the gold standard during the Great Depression, it would have alleviated the hardship on the people. In his book "Essays on The Great Depression", Bernanke values this reprieve higher than preserving the purchasing power of the dollar. In the past, only the Treasury Secretary talked in public about the U.S. dollar. Bernanke, however, has made the U.S. dollar a focus of his decision making process. By considering the U.S. dollar a valve to alleviate hardship, he throws the baby out with the bathwater.
We are not in the Great Depression. Importantly, because of significant current account and budget deficits, our position versus our trading partners is far weaker than during the 1930s. If we make the U.S. dollar less attractive, foreigners may well demand to be compensated through higher interest rates. Incidentally, in a recent speech in Germany, Bernanke pointed out that longer-term interest rates are likely to move higher. He thinks that we may see higher long-term interest rates within the next decade. In our opinion, we might be faced with higher long-term borrowing costs much sooner. Bernanke seems to subscribe to the view that borrowing costs will be contained because it is in no one's interest for the dollar to plunge and for foreigners to refrain from purchasing U.S. debt. He is right that in particular Asian economies are highly dependent on selling to American consumers; in our assessment, much of Asia rather destroy their own currencies than to allow the dollar to fall too much, as it would throw their domestic economies into turmoil. But that does not mean one can turn good policy upside down and force foreigners to invest in the U.S. This is where academically trained central bankers looking at econometric models of past behavior are playing with fire. At the end of the day, market forces are stronger than central bankers, and bad policy will cost dearly.
The major downside risk of a weaker dollar is inflation. Consumers see it best at the price at the gas pump. But as foreigners may reduce their appetite for U.S. debt, and as the market as risk continues to be priced back into markets, credit will continue to be tight. Tight credit means less economic activity, a recession. Central bankers ought to take away the punch ball when the economy gets too hot; instead, the current breed at the Fed seems to believe recession is a four-letter word.
Does anyone benefit from the lowering of interest rates in this environment? In conjunction with higher long-term rates, it steepens the yield curve. Banks tend to have short-term deposits (the short end of the yield curve) and lend money for longer-term projects (the long end of the yield curve). The Fed's policies are thus aimed at restoring profitability at banks. The challenge for the Fed is, of course, that it is difficult to help both mortgage holders (and with it consumer spending) and banks at the same time, as the policies required to assist each group are diametrically opposed. The Fed may be better of getting out of subsidizing pockets of the economy and instead focus on what ought to be its mandate, to preserve price stability.
The Fed's efforts to boost liquidity in an environment when market forces call for a recession will cause commodity prices to continue to be at elevated levels. It is not surprising that the Canadian dollar has reached parity versus the U.S. dollar: Canada is a resource dependent economy that has its fiscal house in order. The major downside risk for Canada, their dependence on the U.S. economy, is mitigated by the Fed's determination to keep at least resource utilization at high levels.
The European Central Bank (ECB) has so far recognized the distinction between the varying challenges the markets face. By keeping interest rates high, they acknowledge that inflationary risks are real. Switzerland just raised rates, also acting prudently. There has been a lot of criticism of the Bank of England's (BoE) flip-flopping. While we share much of the criticism, we have called the BoE a yoyo-central bank for some time and are not surprised by their actions: of the Western central banks, the BoE has the most volatile policy, reversing course on policy decisions rather frequently; the Brits wouldn't want to live without this "flexibility"; on a more serious note, this behavior is well priced into the British pound.
A weak dollar may boost the earnings of a couple of multi-nationals based in the U.S.; but it will weaken the competitive position of the U.S., planting seeds for more protectionist policies in the future. And a country dependent on the mercy of foreign creditors can ill afford protectionism. Rather than protectionism, the solution is to cut spending, for the government to live within its means.
In the more likely event that the government will not drastically reduce its spending in the wake of a slowing economy, investors may want to consider how to navigate through what the future bears. We believe that risk continues to be under-priced, and that the credit contraction will not only continue for much longer, but that it will further spread to overall corporate and consumer activity. Budgets for 2008 are decided upon now; many companies prefer to err on the side of caution in the wake of the recent turmoil. For Gross Domestic Product (GDP) growth to turn negative, we only need to have much of corporate America institute marginal cutbacks.
We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. As a result, some say we may be biased in our outlook. We would like to point out that we brought this product to market in 2005, as we predicted an environment in which investors may want to mitigate equity, interest and credit risk, but also diversify out of the U.S. dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.
