Another Review of our Liquidity Indicators
(February 13, 2009)
Dear Subscribers and Readers,
Another day, another initiative by the Obama administration to prop up the US economy and financial market. Just before the market closed yesterday, a Reuters story confirmed that the Obama administration is set to announce a plan to reduce interest rates on mortgages owed by struggling homeowners, as part of a broader plan to bring further relief to borrowers and housing prices. Not only will this directly add $50 to $100 billion liquidity to US households (and in a more immediate way than parts of the $789 billion fiscal stimulus plan), this will also help maintain money velocity by providing a cushion to holders of mortgage-backed securities, including banks.
Make no mistake: The Obama administration, despite not having the mandate that FDR did in his first 100 days, is now pulling all the stops to arrest the crash in the US, and nearly by default, the global economy. Starting with the Emergency Bank Act of 1933 (whose entire legislative process took less than six hours), FDR rammed 15 bills through the Congress during the 100 days it was in session – getting a perfect score, with 15 bills passed – from the Farm Credit Act (which provided loans to farmers for agricultural production and low interest rates to farmers facing foreclosure – at the time when nearly 25% of population were still farmers), to the establishment of the Home Owners Loan Corporation (which purchased mortgages of homeowners threatened with foreclosure and reset mortgages to 30-year terms at a 5% interest rate – sounds familiar?), the Tennessee Valley Authority, the Glass-Steagall Act, and the first unemployment benefits pool. The Dow Jones Industrial Average set a higher low during the days of the FDR's inauguration in early March 1933, rallied, and never looked back. Until there are signs of a sustainable rally in the stock market or a significant narrowing in corporate yield and credit card spreads, the Obama administration will continue to find innovative ways (or follow the FDR playbook) to revive the US economy.
All these stimulus and rescue plans could not succeed without the buy-in of the Federal Reserve. Since our last review of our liquidity indicators two weeks ago, the Federal Reserve's balance sheet (Total Reserve Bank Credit) has shrunk by another $200 billion. Reserve Bank Credit declined from a peak of $2.23 trillion in early December of last year to “merely” $1.83 trillion today – a total decline of $400 billion in just two months:
This $400 billion decline in the Fed's balance sheet is mostly due to the recent declines in loans to depository institutions and support to money market funds holding asset-backed commercial paper. In addition, the Fed has actually sold some of its commercial paper that was held to support the commercial paper market, as well as pared back its liquidity swaps with other central banks as currencies across the world stabilize (with special emphasis on the South Korean Won, the Australia Dollar, and the Canadian Dollar). While the asset-backed securities market is far from “business as usual,” the run from non-Treasury money market funds that followed the Lehman bankruptcy has already run its course. Because of this, it is no surprise to see the Fed winding down this facility. Moreover, given the latest backing from the US Treasury's new Financial Stability plan to support the banking system, and given the easing of the Fed Funds/LIBOR market, it also made sense of the Fed to wind down its loans to depository institutions.
Of course, this does not mean that the Federal Reserve won't find more creative ways to utilize its balance sheet. As we mentioned previously, the Federal Reserve has made clear it will continue to support the mortgage and housing markets by purchasing agency debt and agency MBS. In fact, over the last week, the Federal Reserve bought another $23.2 billion in MBS backed by either full government institutions or GSEs:
Over the last two weeks, the Federal Reserve bought a total of $45.5 billion of MBS backed by full government institutions or GSEs. More importantly, the Federal Reserve, concurrent with Tim Geithner's speech on Tuesday, announced a dramatic expansion of its Term Asset-Backed Securities Loan Facility (TALF) from its initial plan of $200 billion (announced back in November of last year) to as much as $1 trillion. In other words, the Fed will literally be printing nearly $1 trillion to fund its purchases of newly-issued AAA-rated asset-backed securities, including AAA-rated CMBS, private-label RMBS, and securities backed by auto loans, auto leases, and credit card receivables. The start date of the TALF program will be announced later this month, and can be quickly implemented once it is announced. Combined with the current rate of Fed purchases in the MBS market (about $100 billion every four to five weeks), the size of the Fed's balance sheet could easily surpass $2.5 trillion sometime this summer. Should the Federal Reserve go through with its plans to purchase longer-dated US Treasuries, my sense is that the size of the Fed's balance sheet could rise to nearly $3 trillion by the end of the summer.
I would offer my thoughts and analysis on the Obama administration's Financial Stability Plan this weekend. For now, it looks like the Obama administration is doing everything it can to arrest a further decline in the US economy – and is now being consistently proactive rather than reactive. The danger, of course, is in the implementation of such a plan, as there are many executive issues that still need to be hashed out. Assuming that we maintain some stability in the global banking system, any stimulus or new liquidity facilities implemented by the Fed should provide tremendous benefits to both the US and global economy (and of course, the stock market). In the meantime, the fact that China has exhibited relative strength is highly encouraging, as the US will definitely need the Chinese economy to raise its domestic consumption and imports in order to embark on a sustainable recovery. The Shanghai A-shares are up over 25% on a year-to-date basis, while the value of loans made in January rose 170% from January 2008. More importantly, both the Chinese government and Chinese consumers have ample “fire power” (especially given China's benign demographics and increasing productivity) to keep her economy growing at the 6% to 8% rate that I am anticipating for 2009. With Chinese consumer price inflation now cooling down to just 1%, I expect the People's Bank of China to cut rates again in a few weeks. Finally, the European Central Bank has also indicated it may pursue certain unconventional monetary tools in order to revitalize the Western European economy, even before it cuts its policy rate to zero. Again, I will put together more thoughts this weekend.
Henry To, CFA