FT Today: Paulson Says Crisis Sown by Imbalance

Dog bites man headline to start.

Later in the article we get this:

“Excesses . . . built up for a long time, [with] investors looking for yield, mis-pricing risk,” he said. “It could take different forms. For some of the European banks it was eastern Europe. Spain and the UK were much more like the US with housing being the biggest bubble. With Japan it may be banks continuing to invest in equities.”

This argument – already advanced by a number of economists and largely endorsed by Federal Reserve chairman Ben Bernanke – suggests that the roots of the crisis do not simply lie in failures within the financial system.

It also implies that avoiding crises in future will require global macroeconomic co-operation as well as better financial regulation and risk-management.

Global macro cooperation? Please, stop, here is the problem -- policy makers are acting as if free trade means free floating exchange rates. Nothing can be further from the truth. Check the difference in dollar depreciation against the trade weighted index of major currencies and the dollar against the trade-weighted index of "Other Important Trading Partners", namely China, India, Korea, Russia, and Brazil.

If these countries insist on keeping their currencies effectively pegged to the dollar, the Fed has to be the central banker for everyone and, in a sense, punish them for that by raising interest in the U.S. when credit growth is accelerating too fast in the U.S., not inflation. Credit growth should be the main focus of policy, and the Fed should not worry about what bubble the credit growth is feeding. Because you know what? If the Fed keeps overall credit growth within bounds, there will be no asset bubble like the housing bubble and the high tech bubble in the 1990s. And if there is one, and the Fed has kept credit growth within bounds, well then caveat emptor.

Macropolicy today, fiscal and monetary, appears to be focused on getting the economy back to where it was by keeping the dollar at uncompetitive exchange rates, swapping collapsed private debt with public credit, and allowing huge surplus nations to sustain an effectively fixed currency. We will get recovery but nothing will have been accomplished and down the road the next collapse will be worse than this one. Recessions, depressions really, are about restructuring what went wrong not just getting the economy rolling again by putting humpty dumpty back together again. And the restructuring does not mean government taking control of the means of production and the distribution of capital. Re-regulation? Absolutely. But lets make all these financial institutions smaller not bigger. More on that in a different post.

As important as recovery is, it is equally important that recovery comes with free floating foreign exchange rates everywhere or a Fed reaction function keyed to credit growth rather than inflation. In truth, we should have both but credit restraint means no inflation. And let's stop worrying about the dollar as if it's strength reflects national manhood. The mercantilist countries, including Japan, don't seem particularly concerned that their currencies trade cheap why should ours? Okay, competitive devaluation is bad, absolute truth, but like I wrote above this is not about pegging exchanges, quite the opposite, it is about letting the market decide.

ZIRP & The Economy To Emerge

In this attempt to get the economy going again a deep breath and a bit of thought seems in order. If the problem today is that consumers are too levered and in fact the economy is built on too much debt relative to national income, then the solution is to make debt cheaper? I know policymakers are trying to avoid depression, a valued goal, but it seems to me that they are now replacing consumer leverage with government leverage to get the economy back to the pre-recession level of economic activity. Considering all the talk about de-leveraging the U.S. economy because it is living beyond its means then shouldn't we be managing the shrinking of the economy through debt relief and loan modification to prevent wholesale asset sales rather than desparately trying to pump the air back into the balloon?

Perhaps a better solution to the current situation is to let the dollar fall. Now I know there are many of you who consider the currency's strength as an indicator of economic fortitude -- well this is an "old Europe" (to borrow a phrase) idea and certainly not an Asian one. And yes, competitive devaluation is overall destructive. My suggestion is not devaluation so much as letting the dollar fall to its fair price. Or, in other words, let the other currencies rise to theirs.

The whole story is a lot longer and this being a blog my promise is to keep it short. Looking at the markets, the rush for Treasurys continues unabated and the TIPs continue to price near term deflation. The so-called Treasury bubble is being created by two market forces of demand. First off, the Fed is buying. Second, and more important, no one wants to show anything in their portfolios other than Treasurys. Third, the rest of the world isn't doing so well and a lot of foreign buyers prefer the safety of U.S. Government securities. Once the year turns I would expect Treasurys to cheapen some but not a whole lot.

ZIRP!

ZIRP reads more like one of those words in a Don Martin cartoon in Mad Magazine. You know, several panels of some funny looking guy eating all sorts of stuff and then in the last panel he puts his hand over his mouth and he goes "ZIRP!!!!"

I am not exactly sure what the cartoon character would have been eating but the Zero Interest Rate Policy, what ZIRP means here in the real world, means the Fed is going to digest a whole lot of Treasurys, Agencies, and Agency MBS. They also announced today that they are staying with this program for a long time to come. Inflation is no longer a concern. Amazing, isn't it, that this is the same group that in the spring was hinting at a rate hike at this point in the year because inflation was stubbornly high. Now it has decided to throw everything it got into the market.

To what effect? To punish investors for holding cash and government related securities. They are going to force the risk spread so wide that speculators first and investors second will begin to buy credit and return liquidity to a frozen market. The Fed is also saying to President Obama that they are standing aside and supporting, whole hog (so to speak), an enormous fiscal initiative. Which is obviously the second and necessary action if anyone is going to put up cash behind the belief that more credit will survive than go bust.

There is also the dollar play here, in other words a weaker one at first but, counter intuitively a much stronger one later on once growth takes hold and again global investors see this economy as the world's most important consumer.

Hate to throw cold water on the party, and while the Fed is doing the best it can under circumstances made worse by its gross misread of the economy when it was booming and when it started going bust. What got us into this mess is too rapid credit expansion, housing this time, high tech in the 90s, who knows what's next. All of it was fueled by an ever increasing inflow of foreign capital. The Fed, and here it is complicit in all this, chose to ignore the credit growth and the trade deficit believing the dollar would correct all of it. No such luck, the dollar is effectively fixed against our major trade surplus countries and so it was and is up to the Fed to do what a free exchange rate market would have done -- raise the real cost of capital in this country.

Enough history, looking forward policy today smacks a little bit like the hair of the dog on New Years Day. If the solution is to try and put the economy back together where it was, we will be here again. So a hair of the dog is okay considering the immediate alternative, but if we don't decide to stop drinking nothing will have been accomplished. And don't be surprised if the economy comes roaring back faster than expected. Remember those forecasting gloom were forecasting anything 12 months ago. There are other reasons, more solid ones than that, but I leave that for another post.

FOMC, GDP, ISM and YOU

Not sure the iambic pentameter is working here, but hopefully the title catches your attention to the onslaught of data and the Fed. Stronger than expected GDP despite a 19% drop in residential investment, which took 1.2 percentage points off of growth, and an FOMC statement that moved the Fed from Dec's worrying about growth to confidence that the economy will grow -- while acknowledging that inflation has ebbed.

The market, in its infinite wisdom, rallied on the news, believing that the comments on inflation were setting the stage for an ease later this year. Since December, the market has moved its ease scenario out in time and down in its extent, but it is still betting on an ease beginning in August but definitely by December. Some of the market gurus, mostly wrong but never in doubt, are out there pitching the idea that softness is to come, 4th Q was a statistical anamoly, and look for an ease by July.

Markets want to read into to the statement what they want to believe. I believe something different. The Fed is telling us that the concerns they had about growth are past or at least passing, so they can be more confident in their forecast of continued moderate growth. As for inflation, they acknowledge the drop and they know it is energy related. They are also saying that resource use is tight and thus the risk for inflation remains.

So, tell me, if the Fed is confident about growth, which means greater utilization of resources, why does the market think the next move is an ease?

Two things to remember about this economy. First, it runs on credit and there is plenty available. Second, this economy is "adapt and grow". It has adapted to 5.25% funds, which is not restrictive, and so the economy is ready to grow. I believe that, the Fed believes that, the market savants that were convinced of a consumer implosion and recession last year -- don't.

Some Berry Good Thoughts . . . . So What Does Trigger The Fed

In today's Bloomberg, John Berry writes that the Fed is going to do more of the same -- watch, wait, and note that the greater risk is inflation. Inflation is the risk because money is cheap and available and as long as credit can expand so too can the economy.

How easy is money? This was reported in this morning's Wall Street Journal:

The investing arms of Goldman Sachs Group Inc. and Morgan Stanley are quietly collaborating on a massive private-equity play for the oil-and-gas assets of utility company Dominion Resources Inc. -- a deal that could top out at $15 billion, people familiar with the matter said.

When $15 billion and play are in the same sentance, money and credit aren't being rationed.

Back to Berry.

He sets the stage by writing:

A few weeks ago, many financial analysts were predicting that slowing growth would prompt the Fed to adopt more neutral language at the Jan. 30-31 meeting in preparation for reducing the target in March or May.

That prediction was a major misreading of Fed thinking.

I should say so. But the street savants are often wrong but never in doubt. So where does Goldman, the erstwhile private equity player, stand? Again, from the Berry article:

On the other hand, economists at Goldman Sachs Group Inc. haven't abandoned their forecast of 75 basis points of rate reductions in 2007, beginning by midyear.

Perhaps their economists should have lunch with the private equity guys. Since investors risk the firm's capital, the proverbial money going where the mouth is, I side with the risk takers.

Here is the meat of the story, at least to me:

Their counterparts at Macroeconomic Advisers LLC, who don't expect any such slowing in job growth, said in their weekly forecast update on Jan. 19 that they ``expect the Federal Reserve to maintain the fed funds rate at 5.25 percent throughout 2007.'' . . . .

. . . . They went even further, adding: ``The next decision for the Fed will be whether to resume tightening or to remain on hold, given the economy's apparent resiliency and the upside inflation risks emanating from tight labor markets.''

That's not a decision that is going to be on the table next week, however.

A number of Fed officials have indicated in recent speeches that they are quite comfortable with the current 5.25 percent target . . . .

They become uncomfortable if the curve flattens enough such that the market prices in a tightening before the Fed does. This occurs if data begin to reveal what this blog has been saying -- too much money chasing too few opportunities. As long as the curve behaves, so too will the Fed.

In sum, the Fed now turns a bit from data dependancy to watching the watchers.

Silent Savants, Golden Moments

Readers of this blog should be expressing a "what took so long" approach to the market sell-off rather than any suprise. The theme on this site has been questioning the market's obsessive pricing of Fed eases amidst expectations of a collapse in personal spending on the heels of collapsing home prices. The consistent answer to this view has been that the money creation process (that is bank lending) continues apace without any meaningful tightening of credit standards. Credit expansion trumps any concurrent slump in real estate pricing. Ask Sam Zell if there is a problem finding money to chase a mixed bag of properities. Continued lending by the banks is the reason why the inverted curve was indeed different this time around.

This is what Fed officials have been yapping about and why they remain vocally concerned about monetary inflation -- not the mere follow through of a commodity price spike. They have let us know that they anticipate some wage inflation in response to the multi-year trend that shifted earnings to the owners of capital and away from workers. The line between catch-up and inflation is for them to define.

While the FOMC waits and watches, you can expect the Fed to continue to talk a tougher game than they are playing. Market yields will continue to rise as ease expectations are unwound. Fed policy stays on the sidelines until the market approaches a positive curve that says the Fed is lagging economic events. Not something Bernanke would like to see. Until that time, mixed data and the unwind of those ridiculous expectations of Fed eases. Wonder what all the "street savants" will be saying after there is a no go at the end of the month.

Apologies for not writing since mid December. I have been taking time off and rearranging life priorities. My words of wisdom, balderdash to others, returns on a more regular basis in the next several weeks.

Bonds Spinning In Place

The Fed told us to relax, watch the data mix and reevaluate in six weeks. The market, doing its reflexive best, reacts to every bit of data as a new trend even, at times, a new business cycle. Sometimes the market travels to several different cycles in one day.

The only one position to take with some confidence, and the one the market keeps drifting back to, is what we call the "Poole Scenario" (see table below). Basically it has the Fed easing some 25 to 50 basis points by the middle of next year because growth has slowed enough for long enough to reduce inflation risk. It will either be that or on hold (Unless the data suggest a too weak economy and then we get the ease in January. No ease in January and you can kiss the recession scenario goodbye.) The shift in pricing to Poole means about a 15bp rise in 2 year yields. Fed keeps the funds rates at 5.25%, 40 odd basis point rise in the yield on a 2-year Treasury. Small shift to a tightening bias for midyear (my personal favorite) and 2 year yield rises 52bps.

You pay your money and take your chances. Understand the risk and you can better evaluate the expected return.

As of day's end Friday, the market is giving only a cumulative 16% chance of an ease by Mar and then builds to certainty for the first 25bp cut at the Jun 28 meeting. At the edge of the Poole.

The street economists who gave us consumer calamity for 06 are, being a shameless bunch, still out there pitching doom and gloom or at least a weaker forecast than the Fed's. Like a stopped clock they will eventually be right, but not anytime soon. Certainly not as long as credit remains as plentiful as it is.