Saturday, November 1, 2014

04/29/2011 Henry Simons was Right *

For the week, the S&P500 jumped 2.0% (up 8.4% y-t-d), and the Dow rose 2.4% (up 10.7%). The broad market remains strong. The S&P 400 Mid-Caps gained 2.0% (up 11.9%), and the small cap Russell 2000 rose 2.3% (up 10.4%). The Morgan Stanley Cyclicals gained 2.2% (up 8.5%), and the Transports surged 4.2% (up 8.0%). The Banks rallied 2.1% (down 1.3%), and the Broker/Dealers added 0.1% (flat). The Morgan Stanley Consumer index increased 1.4% (up 4.2%), and the Utilities advanced 2.5% (up 4.8%). The Nasdaq100 added 1.1% (up 8.4%), and the Morgan Stanley High Tech index increased 1.2% (up 5.8%). The Semiconductors rose 1.4% (up 9.2%). The InteractiveWeek Internet index added 0.5% (up 6.1%). The Biotechs gained 1.7% (up 12.7%). Although bullion surged $57, the HUI gold index slipped 0.6% (up 3.3%).

One-month Treasury bill rates ended the week at one basis point and three-month bills closed at 4 bps. Two-year government yields fell 5 bps to 0.61%. Five-year T-note yields ended the week down 13 bps to 1.98%. Ten-year yields fell 10 bps to 3.29%. Long bond yields were down 7 bps to 4.42%. Benchmark Fannie MBS yields were down 12 bps to 4.09%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed 2 to 80 bps. Agency 10-yr debt spreads declined 3 bps to negative 5 bps. The implied yield on December 2011 eurodollar futures declined 2 bps to 0.455%. The 10-year dollar swap spread was little changed at 7.75 bps. The 30-year swap spread declined one to negative 23.5 bps. Corporate bond spreads narrowed. An index of investment grade bond risk fell 5 to 88 bps. An index of junk bond risk sank 17 bps to a one-month low 422 bps.

Investment grade debt issuers included JPMorgan $2.0bn, Express Scripts $1.5bn, and Colgate-Palmolive $500 million.

Junk bond funds saw outflows of $4.3 million (from Lipper). Issuers included Ford Motor Credit $1.25bn, Building Materials Corp $1.0bn, Iasis Healthcare $850 million, Cumulus Media $610 million, IPayment $525 million, Felcor $525 million, Allison Transmission $500 million, Sanmina-SCI $500 million, Brightstar $350 million, Radioshack $325 million, Yonkers Energy $300 million, Xinergy $200 million, and Brown Group $200 million.

I saw no convertible debt issued.

International dollar debt issuers included Indonesia $2.5bn, Hana Bank $500 million, Banco De Galicia $300 million, and Indo Energy $115 million.

U.K. 10-year gilt yields declined 10 bps this week to 3.43% (down 8bps y-t-d), and German bund yields dipped 2 bps to 3.24% (up 28bps). Ten-year Portuguese yields rose 14 bps to 9.50% (up 292bps). Irish yields increased 11 bps to 10.35% (up 129bps), and Greek 10-year bond yields jumped 63 bps to 15.35% (up 289bps). Two-year Greek yields jumped 216 bps this week to 24.36%. Spain's 10-year yields declined 18 bps to 5.28% (down 16bps). The German DAX equities index jumped 2.9% (up 8.7% y-t-d). Japanese 10-year "JGB" yields declined one basis point to 1.20% (up 8bps). Japan's Nikkei rose 1.7% (down 3.7%). Emerging markets were mixed. For the week, Brazil's Bovespa equities index declined 1.4% (down 4.6%), while Mexico's Bolsa increased 0.4% (down 4.1%). South Korea's Kospi index slipped 0.2% (up 6.9%). India’s equities index dropped 2.4% (down 6.7%). China’s Shanghai Exchange sank 3.3% (up 3.7%). Brazil’s benchmark dollar bond yields dropped 18 bps to 4.56%, and Mexico's benchmark bond yields fell 17 bps to 4.32%.

Freddie Mac 30-year fixed mortgage rates slipped 2 bps to 4.78% (down 28bps y-o-y). Fifteen-year fixed rates declined 5 bps to 3.97% (down 42bps y-o-y). One-year ARMs were down one basis point to 3.15% (down 110bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 11 bps to 5.31% (down 51bps y-o-y).

Federal Reserve Credit jumped $12.4bn to a record $2.672 TN (25-wk gain of $391bn). Fed Credit was up $264bn y-t-d and $355bn from a year ago, or 15.3%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 4/27) increased $17.1bn to a record $3.436 TN. "Custody holdings" were up $375bn from a year ago, or 12.2%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.731 TN y-o-y, or 21.8%, to a record $9.659 TN. Over two years, reserves were $2.992 TN higher, or 45% growth.

M2 (narrow) "money" supply rose $12.4bn to a record $8.941 TN. "Narrow money" has expanded at a 3.9% pace y-t-d and 5.6% over the past year. For the week, Currency increased $3.0bn. Demand and Checkable Deposits added $1.7bn, and Savings Deposits increased $11.8bn. Small Denominated Deposits declined $2.8bn. Retail Money Funds dipped $1.4bn.

Total Money Fund assets increased $16.8bn last week to $2.727 TN. Money Fund assets were down $83bn y-t-d, with a decline of $145bn over the past year, or 5.1%.

Total Commercial Paper outstanding increase $7.3bn to $1.106 Trillion. CP was up $137bn y-t-d, or 36% annualized, and was little changed over the past year.

Global Credit Market Watch:

April 26 – Bloomberg (Esteban Duarte): “Spain’s indebted regions are selling bonds at the fastest pace in almost a year and paying about the same to borrow as Portugal before it sought a bailout. Catalonia, which is resisting spending cuts demanded by Prime Minister… Zapatero, led $2.3 billion of state bond sales in the past month… It paid a 5.5% yield on March 28 to borrow 400 million euros ($580 million) of bonds due in 2013… Bondholders are concerned the refusal by regional officials to reduce health-care costs and public works will derail austerity measures… More than half of Spain’s 17 ‘comunidades autonomas’ have budget shortfalls that exceed the targets set last year. ‘Spanish regional bonds haven’t benefited from the spread tightening that government notes have seen this year,’ said Leef Dierks… analyst at Morgan Stanley. ‘There are still concerns about their ability to cut their deficits.’ Local elections on May 22 are making officials reluctant to institute budget reductions that may hurt their chances of retaining their jobs.”

April 25 – Bloomberg (Lisa Abramowicz and Tim Catts): “Companies are staging debuts in the junk-bond market at the fastest pace since 1998, taking advantage of borrowing costs at record lows for everything from building solar-power plants to paying dividends to shareholders. ADS Tactical… joined 512 other companies in selling high-yield, high-risk bonds for the first time in the 12 months ended in March… Debut issuers have helped drive the value of the speculative-grade market to more than $1 trillion from $850.4 billion a year ago… Junk bond sales of $112.6 billion this year compare with $95.3 billion in the same period of 2010, when issuance set a record of $287.6 billion for the full year… Yields plummeted to a record low 7.27% on April 21 from 8.27% a year earlier and 17.1% two years ago…”

April 29 – Bloomberg (Tim Catts): “Corporate bond sales worldwide fell 38% in April from last month as the world’s largest economy decelerated, curbing demand for funds to fuel expansion. Deutsche Bank… led $242.7 billion of company debt offerings globally this month, the least this year, and 3% less than in April 2010… Sales in the U.S. plummeted 41% from last month.”

Global Bubble Watch:

April 25 – Financial Times (Henny Sender in Hong Kong and Jamil Anderlini): “China Investment Corp, the Chinese sovereign wealth fund, will soon receive $100bn-$200bn in new funds from the government… CIC, which has already fully allocated the $110bn it had available for offshore investments, is to get the new money as Beijing seeks to reduce its exposure to US government debt. ‘There has been bureaucratic bickering for a year,’ said one person familiar with the matter. ‘It has been difficult to resolve.’ Recently, a number of senior officials, including China’s central bank governor, have said the country’s foreign exchange reserves are excessive and beyond ‘reasonable requirements’."

April 26 – Bloomberg (Fox Hu and Fion Li): “Haitong International Securities Group Ltd., a unit of China’s biggest brokerage, is ‘willing to pay what’s needed’ to lure bankers from U.S. and European firms as it seeks to double its investment-banking workforce, said incoming Chief Executive Officer Lin Yong. Haitong International… aims to boost its 75-person investment banking division by 50% to 100%, joint Managing Director Lin said… ‘We want to hire the highest-ranking bankers,’ Lin said. ‘I’m willing to pay what’s needed to get bankers from European and U.S. investment banks.’”

Municipal Debt Watch:

April 26 – Bloomberg (William Selway): “U.S. municipal-bond credit ratings were cut last quarter at the second-fastest pace since 2002 amid the ‘toughest year so far’ for state and local governments since the recession began, Moody’s… said. Moody’s said… that it cut ratings on 66 borrowers, including Nevada and Kentucky, and raised 17 in the first three months of the year. The ratio of downgrades to upgrades was 3.9 to 1. The rate trailed only the previous three months, which had the highest ratio since 2002…”

April 26 – Washington Post (Michael A. Fletcher): “The state funds that pay pension and health-care benefits to retired teachers, corrections officers and millions of other public workers faced a cumulative shortfall of at least $1.26 trillion at the end of fiscal 2009… The study… by the Pew Center on the States, found that the pension and health-care funding gap increased by 26% over the previous year. Pew officials said the growing shortfall was driven by inadequate state contributions, an aging population and market losses that accompanied the recession… ‘In many states, the bill for public-sector retirement benefits already threatens strained budgets and is competing for resources with other critical needs, including education, infrastructure and health care,’ said Susan Urahn, managing director of the Pew Center on the States. The report… found that states faced a $660 billion pension funding gap. Meanwhile, retiree health-care liabilities — which most states handle on a pay-as-you-go basis — totaled $604 billion, the report said.”

Currency Watch:

The U.S. dollar index sank 1.5% to 73.033 (down 7.6% y-t-d). On the upside for the week, the Swiss franc increased 2.3%, the South African rand 2.3%, the Norwegian krone 2.25, the Australian dollar 2.2%, the Euro 1.7%, the Danish krone 1.7%, the British pound 1.2%, the Swedish krona 1.1%, the Taiwanese dollar 1.0%, the New Zealand dollar 1.0%, the Canadian dollar 1.0%, the Mexican peso 1.0%, the South Korean won 0.7%, and the Singapore dollar 0.8%. On the downside, the Brazilian real declined 0.6%.

Commodities and Food Watch:

April 26 – Bloomberg (Tony C. Dreibus): “Global food prices may rise 4.4% to a record by the end of the year, driven by demand for meat, oilseeds and grains used to make ethanol, adding to costs that mean inflation is accelerating from the U.S. to China… Global corn stockpiles are shrinking the most in seven years, inventories of nine edible oils will drop to the lowest since 1974 and U.S. beef stocks will be the smallest since 1999, the U.S. Department of Agriculture estimates.”

The CRB index gained 0.8% (up 11.3% y-t-d). The Goldman Sachs Commodities Index added 0.9% (up 20.1%). Spot Gold surged 3.8% to a record $1,564 (up 10%). Silver jumped 5.5% to $48.60 (up 57%). June Crude gained $1.64 to $113.93 (up 25%). June Gasoline rose 3.9% (up 39%), and May Natural Gas jumped 5.2% (up 7%). July Copper dropped 5.4% (down 6%). May Wheat dropped 3.8% (down 3%), while May Corn gained 2.3% (up 20%).

China Bubble Watch:

April 29 – Bloomberg (Tim Catts): “China’s urban dwellers swelled to 665.6 million last year, more than twice the population of the U.S., and the number of older people surged, according to figures from the country’s first census in a decade. China had 1.34 billion people as of Nov. 1 last year… People over 60 years old account for 13.3% of the population, 2.9 percentage points higher than in 2000 and a trend that is ‘gradually accelerating…’”

Asia Bubble Watch:

April 26 – Bloomberg (Shamim Adam): “Asia faces a ‘serious setback’ from surging oil and food prices that are fueling inflation and threatening to push millions into extreme poverty, the Asian Development Bank said. The region’s growth may be reduced by as much as 1.5 percentage points should the pace of gains in oil and food prices seen so far this year persist for the rest of 2011… Domestic food inflation in many Asian economies has averaged 10% this year, an increase in prices that may push an additional 64 million people into extreme poverty… Policy makers from China to India and Singapore are stepping up the fight against inflation through interest rate increases or currency appreciation as political unrest in the Middle East boosts crude oil prices. The pattern of ‘higher and more volatile’ food prices is also likely to continue in the short term amid declining grain stocks, the ADB said.”

April 25 – Bloomberg (Shamim Adam): “Singapore’s inflation held at 5% in March as housing and transportation costs surged… Asian central banks from China to Thailand and India are raising interest rates or allowing their currencies to gain to curb price pressures as oil and food costs rise…”

Unbalanced Global Economy Watch:

April 26 – Bloomberg (James G. Neuger and Marcus Bensasson): “Greece’s budget deficit exceeded government estimates and the euro area’s overall debt reached a record, narrowing Europe’s options for putting an end to the fiscal crisis. Greece’s shortfall was 10.5% of gross domestic product in 2010, higher than a 9.4% estimate made by the Greek government in February…”

U.S. Bubble Economy Watch:

April 25 – Bloomberg (David Mildenberg and James Nash): “California’s prison guards make more than twice what their counterparts in Texas get paid, a disparity that underlines the benefits -- and taxpayer costs -- of working for the two biggest U.S. states by population. The average Golden State worker receives about $1 more for every $4 earned by a Texas employee…”

Fiscal Watch:

April 25 – Bloomberg (Alex Wayne): “Texas officials say expanding Medicaid under the U.S. health-care law will cost their state as much as $27 billion. In New Hampshire, the same change is projected to save state taxpayers $49 million. Costs associated with the federal-state health program for the poor are proving to be among the most contentious elements of the law and are fueling Republican calls to repeal the statute. Medicaid will expand in 2014 to cover most Americans earning less than 133% of the federal poverty level, or about $29,000 for a family of four this year. The costs of enlarging the program may be more than double estimates by the Congressional Budget Office… The states say that the combined program expansion may cost as much as $90 billion across 14 years.”

Real Estate Watch:

April 26 – Bloomberg (Alex Kowalski): “Residential real estate prices dropped in February by the most in more than a year, a sign the U.S. housing market is struggling to stabilize. The S&P/Case-Shiller index of property values in 20 cities fell 3.3% from February 2010, the biggest year-over-year decrease since November 2009…”

Speculator Watch:

April 26 – Bloomberg (Kelly Bit): “Winton Capital Management LLC, the hedge fund started by David Winton Harding, bumped Louis Moore Bacon’s Moore Capital Management LLC from the list of the top 20 hedge funds after assets surged by 34%. The $20 billion Winton Capital… climbed to 15th place from 22nd… Moore Capital… fell to 22nd from 20th six months ago, with assets unchanged at $15 billion. London’s Man Group Plc became No. 1 at $69 billion with its Oct. 14 purchase of GLG Partners Inc. Harding, 49, uses computer-driven trading models known as managed futures…”

Henry Simons was Right:

“The establishment of definite, stable, legislative rules of the game as to money, or in other words, the creation of a national monetary system, are of paramount importance to the survival of a system based on freedom of enterprise.” Henry Simons, 1936

Listening to Chairman Bernanke’s Wednesday press conference, I was reminded of the long-standing but forgotten “rules vs. discretion” debate with respect to monetary policy. Dr. Bernanke is an impressive public servant. He is extremely intelligent and a man of integrity. I do believe our chairman seeks to do the right thing, and he would prefer to shoot straight with people. I appreciate all of that, although I have come to the conclusion that the system would be at less risk these days if the Fed were being governed by a less capable, less trusted and less doctrinaire official. We’ve somehow gone from the cult of “The Maestro” to “Genius Professor.” Federal Reserve performance is deserving of significantly less discretion.

I remain deeply troubled both by Dr. Bernanke’s analytical framework and by the institutional structure of the Federal Reserve System. We are in desperate need of some fixed and definite rules of the game. The backdrop beckons for a cautious approach. Instead, the great monetary experiment runs unabated – an experiment that evolves without serious scrutiny only because our central bank is judged these days largely by its capacity to inflate equities and risk markets. “No questions asked,” as long as the markets are strong. There were no questions Wednesday regarding the relationship of Fed policy and asset Bubbles - past or present.

Our Fed Chairman did adeptly respond to questions on important topics including inflation, commodities prices, and the dollar. One was left feeling comfortable that inflation was low and under the Fed’s control. Commodities price effects will likely prove “transitory.” The dollar, well, it’s just not a problem. Besides, Fed policies will spur a strong economy and resulting foreign capital inflows, all consistent with the view that “a strong dollar is in the best interest of the United States.” The Chairman noted that the dollar’s big rally back in 2008 confirmed the retention of our safe-haven status. It all sounded reasonable and hopeful. In reality, Washington policymaking is corroding long-term confidence in our currency, a non-transitory predicament that will invariably lead to uncertainty, instability and inflation issues. The best we can hope for is another dollar “short squeeze.”

Mr. Simons’ above comment was from a classic article written during the Great Depression. Throughout that period, many questioned the role the Federal Reserve had played in the breakdown of the monetary system and economic collapse. And, importantly, the focal point in contemporaneous analysis was not an incompetent Fed that had failed to act forcefully following the stock market crash. No, most leading economic thinkers at the time pointed blame directly at the Federal Reserve for failing to adequately regulate Credit and protect the financial system and economy from profligate lending, rampant speculation and general financial excess – all during the preceding boom.

The collapse in confidence was the consequence of cumulative (“Roaring Twenties”) financial and economic excess. It was recognized at the time that the Fed had steered badly off course; had succumbed to “New Era” thinking; and had abrogated its responsibility for maintaining stable Credit. The powerful president of the New York Fed, Benjamin Strong, was faulted for his predilection for intervening in support of the markets, while turning a blind eye to speculative excess and Bubble Dynamics.

Wednesday, Chairman Bernanke was asked about a main theme from Carmen Reinhart’s and Ken Rogoff’s book, “This Time is Different:” that historical experience demonstrates that systems require long periods to recover from deep financial crises. Bernanke’s response: “…Certainly part of it has to do with the problems in credit markets. And my own research when I was in academia focused a great deal on the effects of problems in credit markets on recoveries. Other aspects would include the effects of credit problems on areas like housing and so on. And we're seeing all that, of course, in our economy. But that said, another possible explanation for the slow recovery from financial crises might be that policy responses were not adequate - that they, that the recapitalization of the banking system, the restoration of credit flows and monetary and fiscal policies were not sufficient to get as quick a recovery as might otherwise have been possible. And so, you know, we haven't allowed that, that historical fact, to dissuade us from doing all we can to support a strong recovery.”

I certainly have no issue with Dr. Bernanke’s analytical focus on “problems in the Credit markets.” From my study of history (including “This Time is Different”), it has often required decades to recovery from Credit system collapse. In my reading of the incredible experience of John Law’s “Mississippi Bubble” (the introduction of paper currency to France around 1720), I recall one author noting that it was almost a century before the French people again fully trusted banks.

Fundamentally, great care and intense focus must be taken to ensure the soundness and stability of a system’s Credit mechanisms and underlying instruments. This should go without saying, yet our policymaking framework is incredibly deficient in this regard. Indeed, today’s “activist” policy approach sees an extended period of near-zero rates, double-digit-to-GDP deficits, and massive central bank monetization as a prudent course of action. Chairman Bernanke professes that current policy is “not that different from other monetary policy” – when it is clearly unlike anything prescribed in the long history of central banking. He can speak confidently that the Fed has “lots of experience” with this type of policy, when they are actually deep into uncharted waters.

I take strong exception with Bernanke’s framework. His analytical focus rests upon the policy response to a crisis, while the lessons of history point rather directly to uncontrolled Credit expansion and attendant speculative excess as the root cause of major financial crises. It is crucial to have a framework – a doctrine of clearly defined “rules of the game” – that protects the integrity of the system against the type of excesses that risk a crisis of confidence and systemic collapse (such as massive federal deficits and a ballooning central bank balance sheet). This is foreign to current Federal Reserve doctrine.

The danger with discretionary monetary policy – noted by proponents of a rules-based system over the years – is that policy errors have a propensity for inciting only bigger blunders. I argued against aggressive “Keynesian” stimulus back in 2002. Central to my thesis was that policymakers’ so-called “post-Bubble” response was in reality bolstering powerful ongoing Credit Bubble Dynamics and excess. I took exception with the likes of Messrs. Bernanke, Dudley, McCulley and others. Dr. Bernanke’s early Fed speeches, in particular, espoused a radical monetary response to systemic stress. The danger of such an approach was not indiscernible at the time – and definitely shouldn’t be today. In hindsight, it should be clear that misplaced Federal Reserve stimulus was instrumental in fueling the mortgage finance Bubble and deep structural maladjustment

When questioned on inflation, the Fed Chairman repeatedly referred to “well-anchored inflation expectations.” Gold jumped $21 Wednesday to surpass $1,525. Watching the markets bid up the prices for gold, silver, crude and commodities, one is hard-pressed to dismiss the notion that inflationary forces are nowadays especially untethered. The press conference also did little to dismiss the notion that a weak dollar is an important facet of Dr. Bernanke’s reflationary policymaking. It is simply not credible to claim that inflation is contained, while faith and the price of our currency decline on an almost daily basis.

The markets were quite satisfied by the event. The Fed Chairman conveyed that the Fed is in no hurry to remove extraordinary monetary accommodation. He went so far as to state that any rundown of the Fed’s balance sheet (specifically from not reinvesting maturing securities) would “constitute a policy tightening.” This suggested that, after the conclusion of Q2, the Fed plans on strictly maintaining the current size of its holdings. And when “extended period” is eventually dropped from the Fed's statement, there will be at least a couple meetings before “tightening” commences – and this so-called tightening might begin with a period of slow rundown in the Fed’s balance sheet. Bernanke made it clear that the Fed will err on the side of caution all the way through this process. Especially considering underlying structural deficiencies and fragilities, the markets are content to presume that true “tightening” – returning rates to a more normalized level – is likely years away.

Returning to “rules vs. discretion,” Dr. Bernanke’s highly-discretionary policy has been communicated to the markets with great transparency. Never mind the fact that signaling an extended period of aggressive monetary accommodation directly to a highly speculative marketplace was instrumental in fueling past Bubbles.

We’re in need of some rules. We need rules that would ensure that the Fed never again accommodates a doubling of mortgage Credit in about six years. We need rules that ensure that the Fed is not complicit in double-digit-to-GDP federal deficits – and a doubling of federal debt in less than four years. We need some rules that ensure that savers don’t receive a pittance on their savings while speculators enjoy a historic windfall.

We need rules to ensure that the Fed judiciously monitors financial conditions from a broad perspective. We need rules that would impose discipline when our economy runs persistently large Current Account and fiscal deficits. We need rules to ensure that emergency monetary policy measures have defined durations – helping to limit the structural impact from artificially low interest rates. We need to have rules to ensure that intervening in the marketplace is not commonplace. We need rules to ensure that the Fed doesn’t use the manipulation of financial markets as a mechanism to bolster the economy. We need rules to ensure a policy focus on underlying Credit conditions rather than asset prices. We need rules to ensure monetary policy does not nurture speculative excess. These rules would incentivize the speculators to bet on the system gravitating toward stability – as opposed to these days where the sophisticated speculating community wagers confidently that excess will beget only greater excess.

We need rules to ensure that Federal Reserve policymaking does not dictate the (re)distribution of wealth throughout our society. We need rules that would ensure that the public and financial markets do not expect too much from monetary policy. We need rules that would forbid the Fed from monetizing debt, ballooning its holdings, and massively inflating system liquidity – at its discretion. Rules are needed to ensure that monetary policy doesn’t dictate decision-making throughout the entire economy.

And we so need a framework of rules that would work toward ensuring that the stability of our monetary system is beyond repute – that society need not fear that policymakers will devalue their savings or jeopardize the Creditworthiness of our nation’s obligations and financial system. And we need rules to ensure that the ideology of a single appointed central banker cannot have a profound impact on the nature of monetary policy, asset prices, debt structures, speculative dynamics, financial flows and resource allocation. The risks of indiscretion are much too great, and Henry Simons was absolutely right.