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Seven Faces of “The Peril”?
Chris Ciovacco of Ciovacco Capital Management sent me this interesting comment:
If
you have followed the Fed for any length of time, you know they give
every syllable careful consideration when making any kind of public
statement. You don’t need to have a Ph.D. in Fed watching to
understand yesterday’s release of James Bullard’s paper concerning
quantitative easing is a carefully calculated move to signal to the
markets the real possibility exists the Fed will begin buying Treasury
Bonds in the not too distant future.We read Mr. Bullard’s Seven Faces of “The Peril”
last night and put together a “read between the lines” interpretation
of what it could mean to individual investors and the value of assets
in the coming weeks and months. Regardless of whether or not you agree
with or feel this type of policy will be effective in the longer-term,
there is no question the Fed can significantly alter behavior and
impact asset prices in the short-to-intermediate term. This means an
announcement of quantitative easing in the coming weeks could
significantly impact where stocks, bonds, and commodities settle on
12.31.2010.Our detailed comments on quantitative easing and Mr. Bullard’s paper can be found in: Reading Between The Lines: Bullard’s Paper:
After reading James Bullard’s twenty-three page paper on possible
monetary responses to further economic shocks, we feel it is important
for investors to gain a basic understanding of how future Fed policy
could impact the value of an individual’s savings and other financial
assets. The basic premise of Mr. Bullard’s work is as follows:
- Current
Fed policy keeping interest rates low for an extended period may be
causing the economy to fall into an undesirable steady state of low
nominal interest rates and low inflation expectations.- This undesirable steady state is similar to what sparked Japan’s lost decade.
- Current
Fed policy reinforces a low expectation of future inflation, which in
turn helps keep inflation at bay as market participants feel no
compelling reason to take actions in preparation for future inflation.
These actions might include investing, buying hard assets, or taking
out a loan before interest rates go up.- Keeping rates low
for an extended period also creates a perception that “things must be
bad; therefore, it is not a good time to hire, expand, or take risk".- If there is no credible reason to believe policy or inflation rates are
about to change, there is no impending event to prepare for future
inflation.- Rising inflation expectations can become a
self-fulfilling prophecy as market participants begin to prepare for a
future with higher inflation and higher interest rates.- The
best way to shock market participants out of the undesirable steady
state is to begin a program of quantitative easing, where the Fed
purchases U.S. Treasuries.- In order for quantitative easing
to sufficiently increase future inflation expectations, market
participants must believe the Fed will do "whatever it takes for as
long as necessary" to obtain the objective of sufficiently positive
inflation. This means the Fed must be willing to leave balance sheet
expansion in place for as long as necessary to create expectations of
higher future inflation by market participants (consumers, investors,
companies, etc.). This remainds us of past "bazooka-like" policy moves,
where policymakers would say, "You think we can't create positive
inflation? Just watch."What could all this mean to me and my investments?
Let’s
start with quantitative easing, where the Federal Reserve buys
Treasury bonds. Using a hypothetical example to illustrate the basic
concepts, assume a typical American citizen has some Treasury Bond
certificates in a shoebox under their bed. If the Fed offers to buy
those bonds, they will be exchanging paper money, not currently in
circulation, for a bond certificate. After the transaction, the
American citizen has newly printed money and the Fed now has a bond
certificate. It is easy to see in this example the Fed has increased
the money supply by buying the bonds. The Treasury Bond represents an
IOU from the U.S. Government. When the Fed buys bonds in the open
market, it is like the government buying back its own IOU with newly
created money. This is about as close to pure money printing as it
gets.
How is this policy any different from lowering interest rates or increasing bank reserves?
Lowering
interest rates and flooding the banking system with cash has one major
drawback; if the banks won’t issue loans or customers do not want to
take out loans, the low rates and excess bank reserves do little to
expand the supply of money in the real economy. Therefore, these
policies can fall into the "pushing on a rope" category. Quantitative
easing, or Fed purchases of Treasury bonds, injects cash directly into
the real economy, which is a significant difference.
How could all this create inflation and why should I care?
In
a simple hypothetical example, assume we could keep the amount of
goods and services available in the economy constant for one year.
During that year, the Fed buys enough Treasuries to exactly double the
dollar bills in circulation. The laws of supply and demand say if we
hold supply constant (goods and services) and double demand (dollars
chasing those good and services), prices will theoretically double.
Obviously, if the prices of all goods and services doubled, the
purchasing power of your current dollars in hand would be cut in half.
This is known as purchasing power risk.
If the Fed starts buying bonds what could happen?
Since
the Fed would be devaluing the paper currency in circulation, market
participants would most likely wish to store their wealth in other
assets, such as gold, silver, oil, copper, stocks, real estate, etc.
The mere announcement of such a program would begin to accomplish the
Fed’s objective of creating an expectation of higher future inflation.
The expectation of future inflation can lead to asset purchases and
investing, which in theory creates inflation by driving the prices of
goods, services, and assets higher. In fact, the creation of this
document and your reading of it assist in the process of creating
increased expectations of future inflation, which is exactly what the
Fed is trying to accomplish.
Chicken or Egg: Inflation Expectations or Inflation
Mr.
Bullard hypothesizes the current economy may need rising inflation
expectations to come first, which in turn would help create actual
inflation since it would influence the buying and investing habits of
both consumers and businesses. If you feel the Fed will “do whatever it
takes” to create inflation, you may decide you need to protect
yourself from inflation by investing in hard assets, like silver and
copper. Your purchases of hard assets would help drive their prices
higher. The mere perception of the possible devaluation of a paper
currency can change the buying and investing patterns of both consumers
and businesses.Wild Card Makes 945 to 1,010 on S&P 500 Difficult
From
a money management perspective, understanding possible Fed actions,
especially before high stress and volatile periods arrive, can assist
you in making more rationale and well planned decisions. Even prior to
the release of Bullard’s paper, we hypothesized some possible market
scenarios on July 22, 2010 in Bernanke, the Fed, Deflation, and the Dollar. The comments from July 22nd still apply, but it appears now as if the Fed would move directly to an asset purchase program.
How serious is this?
We
should stress Mr. Bullard’s work relates to contingency plans only.
He states a deflationary outcome could occur in the U.S. "within the
next several years". In a conference call on Thursday, Bullard said,
"This is a matter of being ready in case something else hits. What if
there's a terrorist attack? What if there is some kind of trouble in
the Asian recovery or something like that?" He added, "The most likely
possibility from where we sit today is that the recovery will continue
through the fall, inflation will start to move up and this issue will
all go away".
Unfortunately,
sometimes when an option is given to the markets, it forces the hand
of policymakers. This means markets may remain volatile for a time,
maybe even long enough to bring about an announcement of quantitative
easing from the Fed. We will continue to comment on this topic from
time to time in our blog, Short Takes.
You can download an executive summary of The Seven Faces of "The Peril" by clicking here. I will add on Chris Ciovacco's comments, focusing on what more QE will mean for pensions.
In March 2009, I wrote a comment on how quantitative easing is pushing pensions to the brink. And how are pensions in the UK right now? Reuters just reported that FTSE 100 firms pay record pension contributions:
The FTSE "By Higher Payments The largest reported contribution was by Royal Dutch Shell at 3.3 billion pounds. BAE LCP In "These The If the switch had already taken place the pension deficit would have been cut by 30 billion pounds, LCP said. And public sector pensions are faring worse. The Telegraph reports that Public sector workers need to pay more towards pensions, experts warn:
country's top 100 companies made a record 17.5 billion pounds in
pension contributions last year, some paying more into their schemes
than to shareholders to tackle deficits, consultant Lane Clark &
Peacock (LCP) said.
100 firms increased contributions to defined benefit (DB) schemes by
50 percent to help plug shortfalls due to the market turmoil that hit
pension assets, LCP said in a study published on Wednesday.
some distance, (this is) the highest contribution amount that we have
seen in the past six years," said Bob Scott, partner at LCP and the
report's main author.
contributions as well as rallying markets helped cut the corporate
pension deficit to 51 billion pounds ($78.88 billion) at the end of June
2010 from 96 billion last year.
last year to defined contribution (DC) schemes, the cheaper option
used as an alternative to DB, nearly doubled compared to the last five
years to more than 21 billion pounds.
Systems, British Airways, Invensys, Lloyds Banking Group , Morrisons,
Rolls-Royce, Serco and Wolseley paid more into their schemes than they
did to their shareholders in 2009.
said that one-third of the sample, or 32 companies, failed to make
reference to pension risk or did not report taking any steps to reduce
it in their 2009 accounts.
2009 pension schemes continued to budget for increasing life
expectancy by increasing their members' longevity estimates, which LCP
said added 9 billion pounds to FTSE 100 balance sheet liabilities.
adjustments reflect as well pressure from the pensions regulator and
auditors for assumptions to be more prudent," Scott said.
extra cost of longer-living pensioners could be partly offset
following the government's announcement that inflation increases to
pensions will be switched in future to the consumer price index from
the current retail price index.
Private
sector workers are allowed to pay lower National Insurance in return
for not receiving the second state pension later in life.
But public sector workers are also opting out of paying full national
insurance and yet still receive the second state pension, which is
part of generous public sector pension schemes.
Ros
Altmann, a pension’s expert, said public sector workers should not be
allowed to pay the reduced amount. She also pointed that public sector
workers are benefiting because their pensions are unfunded schemes
paid for by the taxpayer.
She said that by making public sector workers pay the full amount, the Treasury could save £6.6 billion a year.
Her comments were made in a response sent to John Hutton as part of a
Government consultation of public sector pension schemes.
She said: “This complexity has allowed an anomaly for unfunded public
sector pension schemes which costs taxpayers billions of pounds every
year.”
Private sector workers pay 11 per cent in National
Contributions of which 9.4 per cent pays for the basic state pension
and 1.6 per cent pays for the second state pension.
At the same time, public sector workers only pay the lower 9.4 per cent in National Contributions.
The second state pension is effectively a top-up to the basic state pension.
It comes amid growing concerns about the pension industry. A Daily
Telegraph investigation suggested a range of little known fees and
levies typically wipe more than £100,000 off the value of middle
class workers private pensions.
A government spokesman
said: “The lower national insurance payments mean reduced rights for
pensions payments from the State in the future which means lower
costs for the Exchequer.
"Additionally all contributors in
contracted occupational pensions both in the private & public
sectors pay reduced rate national insurance contributions.
"In any case we don’t recognise the numbers being quoted and haven't been shown any calculations."
In the US, the WSJ reports that lawmakers in at least 10 states have voted this year to require many new government employees to work longer before retiring with a full pension, In Canada, there is a big fight between public sector unions that want to keep the momentum on pension reform and the private sector which wants changes to the Canada Pension Plan to take a back seat. But I am not convinced the Fed will engage in more Importantly, the Fed may be Finally, with CMBS delinquencies rising to the highest rate ever,
or have increased penalties for early retirement. A similar proposal
is pending in California. Mississippi, already among the states
requiring more years of service for a pension, is weighing the
additional step of increasing its retirement age.
what does all this have to do with QE? Put simply, more QE will
exacerbate pension shortfalls, at least in the near term, because
liabilities will explode as long-term bond yields fall further. Even if
assets rise, it won't be enough to make a dent in aggregate pension
deficits.
QE. Just the perceived threat that they can come in at any moment and
buy more bonds should scare the daylights out of speculators who are
thinking of massively shorting Treasuries.
jawboning the market down to cap any potentially significant backup in
yields. They will continue flooding the banking system with cash to
reflate risk assets, in an attempt to introduce mild inflation in the
economic system.
the Fed must remain vigilant. Pensions hold a large chunk of
outstanding CMBS, which is why a rise in delinquencies will hit their
portfolios particularly hard. All this means we can expect more pension
reform down the road.
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Speculators are massively shorting treasuries, Leo? Tell me where you see that evidence?
What Im seeing is an empty stock market magically rising with the treasury market saying *YAWN*
You see, eeevil speculators are responsible for everything that doesn't go the bulls' way. If it goes up, it's because of fundamentals and the virtue of noble longs; if it goes down, it's merely a temporary setback completely attributable to the actions of the sworn enemies of truth, justice, mother pie and applehood.
The evidence is irrelevant, because in their vast and shadowy power, they can alter or manipulate any data.
I edited my comment:
I am not convinced the Fed will engage in more QE. Just the perceived threat that they can come in at any moment and buy more bonds should scare the daylights out of speculators who are thinking of massively shorting Treasuries.
This is so easy.....
Which would make for a better economy ?
1) 20, 000,000 Real Entrepreneurs
2) One Socialist Government Head whose revenues are "Entrepreneur" dependent ?
..............................
The point ?
Money should come from the "Entrepreneurship" origin....not of government origin....
................................
And government should be limited to no more than 10%....which really means no more than a 10% portion of all prices....as government is nothing but a very inefficient add on....
Simple question for Bulltard: Can you show us a single example in human history where monetizing debt has actually *worked*?
No one? No one can name even a *single* instance, in the entire history of finance?
I can only conclude that Bulltard is suffering from Faith-Based Economics.
Well, THIS time by the lightning bolt of Zeus massive monetization WILL WORK! muahhh ha ha haaa
Leo says:
"should scare the daylights out of speculators who are massively shorting Treasuries."
That is not correct. The speculative trade has been long Treasuries, not short.
Bruce,
Most of the senior pension fund managers I speak to up here are playing the bull flattener, but speculators are shorting Treasuries, looking for a significant backup in yields. Do you have a link to the latest COT report to see if specs are net long Treasuries? Thx.
QE is actually terrible for pension funds because they are short rates. A fund will have a portfolio of assets, say 30% bonds, 60% equities and 10% other. The bonds tend to be higher quality. On the liability side, the NPV of liabilities is discounted at a AA corporate yield. Any benefit through a rise in assets is more than offset by the rise in the NPV of liabilities through a fall in rates. The inflation element is a bit of a wash, the payments are index linked and there should be (but probably isn't) an offset with equities, but the bonds won't have this. Some funds have inflation swaps, which can help.
The big picture is that monetary policy on its own is like trying to hide a large stain with a small rug, you pull one way and it exposes a different mark. These funds need their investments to grow in real terms, and to outstrip wage rises. Unless QE generates economic growth, then it fails to help.
One final thing, corporations were taking gains in the funds to the bottom line and were discouraged from over paying during the good years and the old actuarial valuations of funds were a total joke, which greatly overstated the health of the funds.
The interesting thing about the UK is that pension claims are a senior unsecured obligation, therefore businesses should be paying into the fund before shareholders. Investors have for too long ignored the risks in the funds (particularly BA and BT and other privatized firms) and then the CEOs try to weasel out of their promises. Shareholders should reward firms that are honest about their pension risks and are taking steps to manage them.
pension funds should buy more CMBS - double down as GS would say.
Its all good.