The Fed's Roadmap
(March 10, 2008)
Dear Subscribers and Readers,
As Agency spreads continued to widen, and as margin requirements for Treasury holdings were being tightened across the board, there were calls earlier yesterday that the Federal Reserve could surprise with an inter-meeting rate cut prior to their official March 18th meeting, similar to what had occurred on January 22nd (eight days prior to the official meeting on January 30th). Even though I believe the Fed remains “behind the curve” (per our earlier discussions on the “Taylor Rule,” record high credit spreads, and the liquidation of various leveraged players), I also do not think they will surprise with another inter-meeting cut. The market acknowledges that the Fed had erred when it did not cut rates more aggressively late last year – however, the “fire fighting” credibility of the Fed still remains intact. Should the Fed surprise with another inter-meeting cut, there could be a more widespread perception that the Fed has “lost control,” or worse yet, don’t know what they’re doing or are up against. During a time of crisis, it is essential for the Fed to show leadership by demonstrating their knowledge of the situation and their effectiveness in dealing with it and other “smaller fires” that may erupt at any time. While it can be argued that the market has forgiven the Fed once before, it may not be so forgiving again.
Of course, we all know that Ben Bernanke, NY Fed President Timothy Geithner, and all his advisors are after all, only human. In the midst of the Panic of 1907, “Jupiter” Morgan was asked if he knew what to do to ease the crisis. He replied that he did not, but that one of his advisors would eventually come up with the right ideas and that those will be implemented in time to stem the crisis. Through his sheer will, personality, and his stature as a financial titan, he was able to bring together all his fellow bankers, the trust Presidents, CEOs of major U.S. corporations, and ultimately even his arch-nemesis, President Teddy Roosevelt on his side in order to resolve the Panic. This was no small feat – while the Clearing House could introduce temporary “certificates” for use as currency in a liquidity crisis, this instrument was not available to the NYSE, the City of New York (which was one step away from insolvency), and the trusts – all of which were not under the jurisdiction of the Clearing House. Moreover, in a world of a quasi-gold standard during the early 1900s, many central banks in Europe were actually raising rates in order to stem the flow of gold to the U.S. – hard currency that was in dire need in New York City at the time.
While Chairman Bernanke may not possess all the financial or economic knowledge required to ease the current credit crisis, it is helpful to note that the world of 2008 is infinitely different to that of 1907 – at least in terms of the tools and policies available to the Fed today vs. in 1907:
- A printing press that could be turned on at will, backed by the fact that the U.S. Dollar remains the world’s reserve currency. All central bankers realize that this needs to be used sparingly – even in a crisis – but this is the “ultimate put option” that JP Morgan did not have, nor did others before him - not even Nicholas Biddle.
- Undeniable cooperation between the Fed and arms of the Federal government, including the executive branch and the legislative branch. Unlike the Mexican Crisis in 1994 – when the Clinton Administration had to bail out Mexico via the Treasury’s Exchange Stabilization Fund – this current crisis has the full backing of the President, U.S. Treasury Secretary Hank Paulson, and Congress. Moreover, similar to the 1998 bailout of Long-Term Capital Management, there is no denying that many of today’s preeminent bankers are also willing to set aside differences and cooperate to bail out various entities, including Ambac and arguably Countrywide Financial.
- As demonstrated in August/September of last year, fellow central bankers across the world have also demonstrated willingness to cooperate with the U.S. to ease this credit crisis. This is important, given the weakness in the U.S. Dollar Index and the spreading of the “subprime virus” across the world.
- An infinite number of tools and reams of data to understand and “project” the Fed’s power in a quick and effective manner. The simple “Taylor Rule” is just one elementary example. The amount and sophistication of today’s financial talent and technology has multiplied exponentially since those fateful days of October - November 1907.
Given the above – and given Bernanke’s knowledge of the immediate causes of the Great Depression and his political genius as a consensus builder and listener (the academic world is infinitely more political than corporate America – one cannot become the Chair of Princeton’s economic department without the necessary political skills) – my sense is that the market will continue to give Bernanke and the Fed the benefit of the doubt, for now.
Again, I do not believe that the Fed will orchestrate an inter-meeting rate cut. Rather, I believe the Fed will try to gradually bring the effective Fed Funds rate down from the target rate of 3.00% until the inevitable rate cut. The effective Fed Funds rate (a volume-weighted average of rates on trades arranged by major brokers) yesterday was 2.98%. Over the last five trading days, this has remained below 3.00%. The lowest was at 2.90% last Tuesday. I am expecting the Fed to gradually ease over the next six trading days without announcing a change in its target until March 18th That is, I expect the effective Fed Funds rate to not only remain below 3.00% over the next six trading days, but to be significantly below that – resulting in a “quasi-easing” by the Fed As for the cut on March 18th, the 75 basis point cut is now a given, but don’t be surprised if the Fed cuts by 100 basis points, since 1) I believe a Fed Funds rate of 2.25% is still behind the curve and 2) the official meeting after next isn’t until April 30th. Make no mistake: I do not believe the Fed will orchestrate another inter-meeting cut again unless it is really forced to do so.
In the meantime, loans and leases held as part of “Bank Credit” in all commercial banks are still expanding at a double-digit rate on a year-over-year basis. In other words, the “liquidity” drought isn’t originating from the “traditional” commercial banks, but rather from the investment banks and other members of the “shadow banking system” who are not regulated by the FDIC or the Federal Reserve. At this point, it is imperative: 1) To make sure that the “liquidity drought” does not spread to the commercial banking sector, and 2) To revitalize the investment banks and the GSEs’ balance sheets and to encourage them to lend and expand their balance sheets. As discussed by Treasury Secretary Hank Paulson last Friday and by the OFHEO yesterday, one of the most effective ways to raise liquidity directly in the housing market is to inject more capital into Freddie Mac and Fannie Mae – given their roles as the leading lenders in the housing market sand given the 25-to-1 leverage of their equity – as opposed to an average of 10-to-1 leverage among the investment banks’ balance sheets. Taking this formula, an extra $5 billion of capital would result in new loans worth $125 billion, which is sufficient for 250,000 households to buy “starter homes” in various parts of California (assuming a $500,000 mortgage). An extra $125 billion in lending in any given year is also close to 1% of GDP, or just $20 billion short of the latest fiscal stimulus package designed to be running in early May. By extension, an extra $10 billion in capital for the GSEs would result in an additional $250 billion in loans – which would go a long way to support housing prices and subsequently the economy.
As I mentioned before, both CalPERS and CalSTRS have gone on record stating their intention and willingness to invest in capital-starved companies such as Citigroup and Merrill Lynch going forward. Given that some of the fund’s investment decisions have been political in nature, it is not a stretch to speculate that either CalPERS or CalSTRS could participate in another round of capital-raising for these two GSEs, should it ever come to fruition. Not only would this be a major benefit to California (given that Californian housing prices have significant downside risks), this could end up being a very good investment as well, given the GSEs’ depressed price-to-book values and assuming the GSEs could help prop up or cushion housing prices across the U.S. (Soros’ theory of reflexivity at work).
In the meantime, I am expecting the U.S. stock market to stabilize at its current level. I do not expect it to continue to sell off, given the tremendous valuations and oversold conditions we are now seeing, but until the Fed lowers rates on March 18th, I also find it difficult to see a rally being sustained until later in March.
For the rest of this week, I expect to update our readers as things develop – so in lieu of our regular Wednesday publishing schedule, I am going to settle for more “ad hoc” commentaries during the week. I may still write a regular Wednesday evening/Thursday morning commentary, but given that things are moving so quickly, I wouldn’t bet on it.
Henry To, CFA