I read Ben Bernanke’s article on the WSJ, and was deceived to see that the focus was on the increase in short term rates. The Fed does count with other options, of course, and Bernanke acknowledged this in the article. But they were not mentioned in detail. As we’ve said many, many times, the problem with inflation is not that prices rise, but that they don’t rise simultaneously. Interest rates are prices too, and when they are manipulated, we are left with price distortion.
Please, click here to read this article in pdf format: july-22-2009
Yesterday, we had an “intraday” correction, driven by the earnings releases for Zions Bancorporation and Regions Financial Corp. The sell-off in these two names was triggered on the most basic of fears: Prospective defaults in commercial real estate clients. It didn’t trigger a huge reaction, but it did bring a bit of perspective, to which we should pay close attention. At the end, Caterpillar’s results could take us to 954.58 (+0.36%) on the S&P500… Yes, we are exploring uncharted waters here…
I read Ben Bernanke’s article on the WSJ, and was deceived to see that the focus was on the increase in short term rates. Yesterday, I wrote that for equities to leap higher, I believe we need some sort of capital markets friendly action. And I defined such action as anything that allows and encourages a flexible price system. Rates manipulation doesn’t certainly fall under that category. The Fed does count with other options, of course, and Bernanke acknowledged this in the article. But they were not mentioned in detail. As we’ve said many, many times, the problem with inflation is not that prices rise, but that they don’t rise simultaneously. Interest rates are prices too, and when they are manipulated, we are left with price distortion.
One would like to believe that, as the Fed uses short-term rates, the shape of the yield curve will not change. Note that I am not worried here about the shape itself, but about changes in the same. If we are to embark on a recovery path, we will do so on the back of an impressive amount of “defensive” issuance in 2009. I like this adjective, which I borrowed from JP Morgan’s Credit Market and Outlook Strategy report, July 17th, 2009. This report indicates that a substantial part of 2009 and 2010 corporate maturities have already been refinanced. Given that such refinancings were not used to fund projects, capital expenditures, but to minimize refinancing risk, stability in the term structure of interest rates is crucial once activity picks up next year.
This is really not a small issue. In September of last year we were laughed at for suggesting that capitalizing financial institutions the Paulson way was not going to boost a recovery. We went on record saying that a real recovery could only take place if governments put a bid on distressed assets. We were criticized on the basis that injecting reserves in the system was a much more efficient way to leverage governments’ capital, assuming the reserves were lent…But they were not! How could they? One only had to reread Keynes’ liquidity trap comments made more than 70 years ago to understand this!
By the same token, paying higher interest rates on reserves will not solve the problem tomorrow. The Fed should SELL ASSETS instead. There is a very subtle difference here, and it merits elaboration:
My critical assumption (axiom) here is that fiscal deficits will keep steady. Thus, when short-term interest rates are increased, regardless of their level, the US Treasury will continue to issue debt to finance the deficit, validating the higher rates. Meanwhile, the average small firm will not be able to cope with the higher cost of capital, and many of them will go bankrupt, in a process that will increase concentration. Spending with fiat money is what fuels inflation, and it doesn’t matter whether the spending is done by private firms or the government! Tax revenue will fall as a consequence, boosting the fiscal deficit, in a spiraling process. Given the financial problems firms face, unemployment will remain high. And the Treasury will be forced to fund more and more fiscal imbalances. Higher rates, inflation, defaults and unemployment will live together.
In the meantime, in Canada, the Bank of Canada has left the overnight rate unchanged, at 25bps. The only worrying issue here is Mr. Carney’s insistence in making public his concerns about the appreciation of the Canadian dollar. The commitment (conditional on the inflation outlook) to keep this rate unchanged until Q2/10 was repeated once more, perhaps to manage expectations in the FX market (= weaken the CAD).
If, on the contrary, the Fed sold assets, it would seek to restore a previous market for them. In the process, if the Treasury wanted to keep funding fiscal deficits, Treasuries would have to compete on a more leveled field with private obligations, given that there would be an oversupply of both private and public paper. The clearing interest rates would be therefore, on average, in line with the issuers’ respective productivity rates and risks. Given the long-term tenor of the majority of the assets currently owned by the Fed, one would think that this process would bring about steep credit and yield curves, forcing the Treasury to look for short-term financing alternatives, bringing a lot of attention to the problem of fiscal imbalances. This latter road is the more difficult, expensive, sincere and productive, which is why it will be the road not taken!
Intraday yesterday, we saw the CDX IG12 flirting below the 120bps level. With the correction in equities, it widened back, to end at 123bps. As credit continues to normalize, we will see with more clarity that the value of good fundamental analysis at the micro level gains more popularity, vs. the systemic view. However, if the Fed is not able to contain inflation, the macro and micro analysis will be equally relevant, as we will need to anticipate the impact of inflation on individual firms’ margins and liabilities management.