Whiskey & Gunpowder
December 9, 2008
By Dan Denning
Melbourne, Australia
The Feds War on Cash
Markets are dithering their way to the end of the year. It doesnt look like much is happening. But some interesting things are going on. Pressure is building. For example, the dividend yield on the S&P 500 is 3.48%. The yield on a 30-year U.S. bond is 3.16%.
According to Mark Hulbert at CBS Marketwatch, 1958 was the last time the yield on the S&P 500 exceeded the yield on the 30-year bond. 1958? Are you kidding? Elvis joined the U.S. Army in 1958. Eisenhower was in the White House, Khrushchev in the Kremlin, and Menzies was elected for the fifth time in Australia.
The world may have lived on the edge of nuclear holocaust in 1958, but at least some things were more certain. You were better dead than Red. What was good for GM was good for America. And everyone liked Ike.
The world is much more confusing today. The yield on S&P stocks was 2% this time last year, a 74% increase in the last twelve months. We reckon stocks will start to look even more appealing when the yield reaches 5% or 6%, which would also mean lower stock prices first.
But theres a bigger story going on, too. Its what we call the Feds war on cash. You see, the Fed is driving down yields on government bonds and notes of all maturities quite deliberately. More on what its up to below. But its not just the Fed thats pulling out all the monetary stops to float the world on a sea of credit.
Its a now a race to the bottom for central bank interest rates. New Zealands central bank cut its main interest rates by a whopping 1.5% overnight. But the Kiwis have some work to do. Short-term rates across the Tasman are still at 5%, 450 basis points above Ben Bernankes Fed.
You dont normally see such aggressive rate cutting in an economy until unemployment levels are much higher. Its the classic Keynesian trade-off between inflation and unemployment. You can keep prices stable by keeping the rate growth low and savings high.
But slow, steady, prudent growth doesnt create jobs fast enough for politicians. So rates are lowered! This leads to lower unemployment rates, but higher inflation. The big change in the last thirty years is that higher inflation was tolerable for most workers in the Western world because it seemed to come with some juicy benefits.
The first was asset price inflation. Houses and stocks went up too! Real wage growth was flat (or even fell). But the value of things you bought went up! On paper, everyone got wealthier.
Then, when China came along and started churning out geegaws and widgets faster than you could slap down a credit card, the apparent virtues of a little bit of inflation seemed limitless. Stocks and house prices went up, but consumer goods, durables, and electronics got cheaper.
This so-called Great Moderation suckered people into a dangerous financial strategy: asset-based saving and debt accumulation. And why not?
In a way, its perfectly rational. If credit is cheap and asset prices are rising, why not borrow to buy stocks and houses? The debt service is low, employment was pretty easy to find, and capital appreciation in your assets would smooth out any rough edges to the strategy.
Well, now that strategy is coming unhinged. In fact, the larger implication is so scary that only people like Robert Shiller dare to mention it: asset price appreciation is not a retirement strategy. It was a good run, from 1982 to 2000. But the idea that the stock market is societys way of managing the risk of old age is now showing its own age. Investors are skittish.
The run on the hedge funds is only restrained by the lock-up periods most investors agree to when turning their money over to a fund manager. But time takes care of that. Investors will continue asking for their cash back if they believe the market is either too risky or too mediocre.
This move to cash must distress the Fed and other central banks. It wants banks to lend, businesses to spend, and consumers to borrow. But the exact opposite is happening. So now we see the Fed doing its best to punish those in cash and force them to spend, or at least get out of government bonds and buy stocks.
Currently banks are content for now to build up a war chest of excess reserves. In fact, theres been a surge in excess reserves held at the Fed by banks, and not just since the crisis began last October (the same is true of cash held at the RBA by authorized deposit taking institutions.
In other words, banks are happy to borrow from the Fed, but sad to lend to anyone. So what do they do? They deposit their new borrowings right back with the Fed, where they earn 1.5% interest (in excess of the target Fed Funds rate).
According to Fed data, U.S. financial institutions had just $60 billion in excess reserves held at the Fed at the end of September. On October 5th, the TARPenstein was passed. By the end of October, excess reserves held at the Fed had grown to $267 billion. By the end of November, it was $610 billion. Dont fight the Fed! Flee to it!
Even a Congressman should be able to figure out whats going on here. Correlation is not causation. But it sure looks like a lot of TARP money has gone straight to banks and financials, whove then put the money hard at work...on the Fed balance sheet, where its safe, secure, and earning 1.5%.
Maybe that was the whole point of TARP anyway. To beef up bank capital positions and not increase lending and spending. But the Fed is busy elsewhere in the bond market trying to get investors out of cash into something (anything!) else.
In a march that would have made General Sherman glow with joy, the Fed is systematically decimating the yield on U.S. government bonds and notes. It is blitzkrieging its way through the U.S. yield curve, buying, or threatening to buy U.S. bonds and notes in order to lower rates.
Dont believe it? Bloomberg reports that the yield on 90-day Treasuries is .01%, while Ten-year U.S. notes yield 2.66%. Both yields are down.
By buying up securities with different maturities the Fed lowers interest rates. Investors crowd in looking for safety and, of course, rising prices. But what is the Fed really up to? Is it really trying to reduce American savers and those on fixed incomes to a state of pauper hood, where a lifetime of savings is consumed in a firestorm of inflation?
That is no way to treat your grandparents. So lets give the Fed the benefit of the doubt and say that the ultimate objective of the policy is to drive interest rates on government bonds so low that savers and more importantly, banks, begin to loan out some of their excess reserves, or better yet, use them to buy distressed assets from each other.
If you want to use a military metaphor, the Fed is dropping big rocks on safe houses from its EZ Money helicopter battleship. One basis point at a time, it is methodically destroying any rational reason for investment advisors to put their clients in Treasuries.
And so if youre not going to be in ultra-safe Treasuries because they are really no better than cash, then what will you do with your money? You have to do something with it. You will spend it. Or invest it.
Either way, you will get rid of it. There is no value in holding it, at least rationally. Emotionally, it feels safe, which is why ten-year yields are back at Eisenhower levels.
So as everyone stampedes toward the perceived safety of the Treasury market, the risk of inflation is grows.
Swell.
Let us turn our attention to an email that had me clapping my hands in glee.
First, its president elect Barack Obama not Mr. O. Show some respect. Second he has already superceded his predecessor simply by being interested and educating himself about the issues. He is at least has a whole brain and can speak intelligently.
You free market rocket scientists have allowed this country to circle the drain due to a lack of regulation and oversight. Obviously, you guys were wrong. This is what the Republicans stand for so it is clearly a flaw in conservative philosophy. There has to be some regulation or you have greed ruling the day. Ask the Romans, the Greeks, and the list goes on what happens when greed is the driving factor.
I consider myself a capitalist and think that we are better off with a free market solution but there has to be some rules for liquidity. I also am a Democrat and I believe that there is a higher good other than my pocket book. You Republican types just dont get it.
I would appreciate less politics and more investment ideas and show some respect.
First, we respect no politicians at the Whiskey Bar. Its company policy
except for maybe Ron Paul
though Jim agrees with you about Mr. O; Lawdy, that guy can orate! Plus hes smart and hes not bad-looking (disclaimer: Ive been told I look like him when I cut my hair).
Im sure Barack is a nice enough guy
for a politician
but hes supposed to be a public servant who works for me, not the other way around. And hes probably going to continue the government tradition of picking my pocket and attempting to destroy any chance I have at happiness. So Ill pass on the part where I feel obliged to pay obeisance to him.
I consider myself to be the sexiest man alive; doesnt make it true. You may consider yourself to be a capitalist, but if you suggest statist solutions, then youre not.
Ill be sure to pass your message to the next Republican I meet. Last I checked, that party was just as interventionist as the admitted socialists they claim to oppose.
For less politics and more investment advice, you could always
click here.
Thanks for the note.
Regards,
Gary Gibson
Managing Editor, Whiskey & Gunpowder
